Inflationary Biases
Doug Nolan
It was an illuminating week, especially Tuesday.
January’s CPI data confirm that inflation is anything but dead and buried.
Headline inflation rose 0.3% for the month versus the 0.2% expected.
Year-over-year headline inflation was 3.1% compared to expectations of 2.9%.
Core (ex-food and energy) CPI rose stronger than expected, with one-year inflation at 3.9%.
“The devil is in the details” is apt.
It's worth noting that despite January’s notable 0.8% rise, Import Prices (from Thursday data) were still down 1.3% y-o-y.
Disinflationary forces in China and elsewhere have supported waning goods price inflation here at home.
In Tuesday’s CPI data, January Core Goods Prices declined 0.3%.
Importantly, however, inflationary forces remain formidable throughout Services pricing.
In data that should have the Fed on edge, monthly Core Services Inflation jumped to 0.7% from 0.4%.
“Supercore” (Services excluding shelter) inflation accelerated in January to a 21-month high 0.8%.
Shelter prices rose to 0.6% from 0.4%, with 6.0% y-o-y inflation.
Medical Care Services gained 0.7%, with Health Insurance prices jumping 1.4% during the month.
Resurgent health services inflation would not be surprising.
Transportation Services jumped 1.0% for the month, led by Maintenance and Repairs up 0.8% (6.5% y-o-y) and Insurance rising 1.4% (20.6% y-o-y).
From Bloomberg Intelligence (Anna Wong and Stuart Paul):
“If Fed officials were hoping to see a broadening of the disinflation process in the January CPI report, their wish didn’t come true.
The share of core spending categories experiencing outright monthly deflation declined to 29% from 44% prior.
The share experiencing modest annualized inflation of 0.0%-2.0% fell to just 6% from 11% prior.
The share of categories with annualized monthly inflation between 2.0%-4.0% held roughly steady at 7%.
And the share of spending categories with annualized monthly inflation of 4.0% or more jumped to 58% from 38% prior.”
Understandably, the bond market didn’t take kindly to stronger and broadening inflation.
Ten-year Treasury yields jumped from 4.15% to 4.28% on the data release, ending Tuesday’s session at an 11-week high 4.32%.
Two-year yields surged 18 bps Tuesday to 4.66% (high since December 12th).
After beginning the week pricing a likely (76% probability) cut at the Fed’s May 1st meeting, by week’s end it was unlikely (36%).
Markets now expect a 4.43% Fed funds rate (90bps of cuts) for the December 18th meeting, 23 bps higher for the week and up 78 bps from the January 12th low.
Volatile MBS yields surged 25 bps Tuesday to a 12-week high 5.91% (ending week at 5.88%).
Equities were under heavy selling pressure.
At inter-day Tuesday lows, the S&P500 was down 2.0%, and the Nasdaq100 was 2.25% lower.
Selling was more intense for the broader market.
The small cap Russell 2000 was down as much as 4.6%, before ending Tuesday’s session 4.0% lower (biggest one-day loss since June ‘22).
Prospects for delayed Fed rate cuts and higher bond yields triggered dollar strength.
The vulnerable Japanese yen quickly sank 1%, pushing the dollar/yen to 150.8 (high since November).
The Dollar Index traded to the high since November 14th, pressuring both developed and developing currencies.
The precious metals were slammed, with Gold down 1.3% and Silver sinking 2.6%.
But a curious thing happened on the way to inflation-induced market instability: Most financial conditions indicators were impervious.
CDS prices remained rock solid at near two-year lows.
Investment-grade CDS increased only 1.5 to 55 bps, with high-yield CDS rising 10 to 354 bps – both only back to levels from the previous Thursday.
Bank CDS barely budged off two-year lows, ending the week further below levels from when the Fed began raising rates.
Treasury and MBS yields surged higher, while small cap stocks suffered their biggest selloff in more than 18 months.
Yet corporate risk premiums (spreads to Treasuries) actually narrowed on the day.
It was remarkable market action worthy of exploration.
February 14 – Bloomberg (Tasos Vossos and Ronan Martin):
“The wave of money making its way into the credit market is acting as a shield for investors against every negative scenario - even the prospect of ever-fewer central bank cuts this year.
Risk premiums on high-grade and junk bonds fell Tuesday despite hotter-than-expected US consumer-price rises that pushed prospects for the Federal Reserve’s first rate cut firmly into the summer.
A gauge of default insurance only rose to levels recorded on Monday.
The continued strength of corporate-bond spreads underscores the numbing effect of persistent flows pouring into credit funds, making managers flush with cash that needs to be invested…
Money flowing into funds focusing on high-grade bonds in the US ‘strengthened considerably’ to about $6 billion in the week to Feb. 7, BofA Securities strategists wrote…
In Europe, high-grade funds recorded their 14th weekly inflow in a row and biggest since June 2020…”
February 16 – Bloomberg (Tasos Vossos):
“Money continued to pour into corporate bond funds in the week that traders pared back expectations for interest-rate cuts, highlighting the asset class’s growing resilience.
Investors added $10.3 billion to global investment-grade bond funds in the week through Feb. 14, a 16th straight week of inflows, according… EPFR...
Data on European credit funds also indicated inflows, with allocations to high-yield portfolios nearly tripling…
The persistent cash flow has helped to buffer corporate bonds from the kind of volatility that’s driving other asset classes as traders try to predict the path of monetary easing.”
Too much “money” chasing risk assets.
Financial conditions remain much too loose, despite the Fed's advertised conclusion of its “tightening” cycle.
While market participants were disappointed by the CPI report, they were in no mood to be dissuaded.
Fed rate cuts are coming, they just might be delayed a bit.
Tuesday developments underscored how powerful Inflationary Biases – in the real economy and financial markets – have major impacts.
The basic premise is that if people have access to money, they typically spend it.
There are innate Inflationary Biases that history teaches must be managed within a framework of sound money and Credit.
Allow the inflation genie out of the bottle, and watch containment become a great challenge.
Print money, and it will invariably be spent on goods, services, real assets, and in the financial markets.
Loose conditions and easy Credit Availability will spur consumer and business spending.
Yet the power of the printing press and loose Credit tend to vary significantly depending on the stage of the cycle.
There are, at today’s late-cycle phase, myriad robust Inflationary Biases.
Consumers have become rather adept at spending, with cash and on Credit.
There has been little impetus in accumulating emergency savings.
Jobs and wage gains have been especially plentiful over recent years.
Moreover, financial innovation ensures a litany of Credit sources to sustain the boom, including non-bank operators hawking alluring lending products such as “buy now pay later” apps and new age subprime business lending.
Today, more Americans than ever are in the markets, tens of millions trading stocks and options online, and tens of millions more through their 401Ks and retirement accounts.
Tens of millions of households have watched their wealth inflate right along with the market value of their homes.
Household Net Worth has inflated spectacularly over this prolonged cycle, especially benefiting from massive pandemic stimulus.
With American households more exposed to the stock market than ever, inflating stock prices these days create a greater boost to purchasing power than they did traditionally.
And market gains tend to be spent more freely than hard-earned wages.
Meanwhile, Inflationary Biases also percolate throughout corporate America.
Surging stock prices ensure bullish narratives and inflating Wall Street earnings estimates.
And loose conditions and easy Credit Availability provide the wherewithal for corporate executives to pursue aggressive growth strategies (to justify inflated stock valuations).
Meanwhile, corporate managements and business owners throughout the economy have grown comfortable passing along higher costs to their customers.
February 15 – Reuters (Lewis Krauskopf):
“The number of S&P 500 companies discussing artificial intelligence has climbed to a new high in fourth-quarter conference calls, Goldman Sachs strategists said, in the latest sign AI is a focal point for markets and corporate America.
The proportion of S&P 500 companies mentioning ‘AI’ rose to 36%, up from 31% in the third quarter, Goldman strategists said…
Companies also noted that spending on capital expenditures and research and development ‘will likely rise in the near term as they ramp up AI investments,’ Goldman said.”
The historic AI mania is a spending black hole.
Under intense market pressure, executives with access to cash and Credit will promote grand plans and spend lavishly on AI.
And the AI Arms Race will drive spectacular earnings growth for the big tech oligopoly.
This only bolsters the stock market mania, further loosening conditions while inflating household perceived wealth.
Inflating markets spur greater speculative leverage, resulting in self-reinforcing liquidity excess.
The inflating market Bubble further stokes household and corporate spending, ensuring a resilient economic boom.
In short, we’re witnessing powerful Inflationary Biases doing what they do best.
The “immaculate disinflation” crowd disregards forceful late-cycle Inflationary Biases at our system’s peril.
Next month will mark three years of y-o-y CPI above the Fed’s 2% inflation target.
Signaling the end of its rate hiking cycle was a major policy mistake.
As should have been anticipated, this triggered a significant loosening of conditions – loosening that only reinforces Inflationary Biases.
Average Hourly Earnings (y-o-y) exceeded 4% every month since July 2001, averaging 4.9% over this period.
For comparison, Average Hourly Earnings averaged 2.7% over the preceding two decades, while not exceeding 3% during the period May 2009 through July 2018.
There has been a fundamental shift in pay expectations over recent years.
Workers expect higher compensation, along with annual raises.
While goods price inflation has been held in check by cheaper imports, services and shelter prices are bolstered by inflating compensation.
With labor markets tight, loose financial conditions will continue to underpin this critical Inflationary Bias.
It was a serious monetary policy flaw to signal a pivot to lower interest rates, before orchestrating the necessary tightening of financial conditions.
A year ago, the Fed seemed to understand that tighter financial conditions were necessary to restrain demand and cool overheated labor markets.
Since then, wishful thinking has supplanted sound analysis.
Financial conditions are today much looser than when the Fed commenced its “tightening” cycle.
Inflationary Biases have become more deeply rooted, both throughout the real economy and in the financial markets.
History teaches us that once inflation takes hold, it becomes very difficult to loosen its grip.
Paul Volcker had to bring the economy and markets to their knees to break inflationary psychology.
At this point, it’s the nature of things that pain will be required to change behavior – to impose the necessary restraint upon Inflationary Biases.
Our central bank is certainly not of the mindset to administer discipline.
So, this historic equities Bubble – currently in full speculative melt-up mode - is left to its own devices.
Observing the craziness, the bond market is positioning for an inevitable market accident.
Low market yields then underpin loose financial conditions, while levered speculation fuels liquidity excess, both feeding the equities market mania along with corporate Credit Availability.
Powerful Inflationary Biases have taken hold throughout non-bank finance - including “private Credit” and investment and insurance products (i.e., annuities) – that proliferate today devoid of market discipline.
Strong private-sector lending coupled with massive federal deficit spending set the stage for a year of inflationary system Credit expansion.
Ten-year Treasury yields rose 10 basis points this week to 4.28%.
It could have been a whole lot worse.
Bonds were given hope Tuesday, as stock market Bubble vulnerability began to surface.
The VIX quickly spiked to 18 (14-week high) – before just as quickly retreating back to 14.
Some sectors (i.e., small caps) turned acutely unstable.
And with the marketplace crowded into big tech, while manic crowds sell options, it’s the ideal backdrop for “Volmageddon2.0”.
And I understand why a bond market focused on equity Bubble fragility and vulnerable global Bubbles would dismiss inflation risk.
But it became clearer this week that powerful Inflationary Biases will be hard at work so long as financial conditions remain loose.
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