I’ve discussed the risk of transitory disinflation before, and it manifested itself in the form of hotter-than-expected January CPI and PPI reports. The reports rattled the bond market and expectations of the first quarter-point rate cut has been pushed out from May to June and a slower rate cut trajectory for the remainder of year.
As a reminder, here is Fed Chair Powell reply in to a question about the timing of rate cuts in his
60 Minutes interview: “We just want to see more good [inflation] data along those lines. It doesn’t need to be better than what we’ve seen, or even as good. It just needs to be good. And so, we do expect to see that.”
The hot CPI report was undoubtedly a shock to Fed officials who had watching a series of tame inflation reports.
The latest BoA Global Fund Manager Survey showed that only 4% of respondents expect higher rates and 7% expect higher inflation. It was therefore no surprise that bond prices skidded badly in the wake of the CPI report.
Do the stronger-than-inflation reports mean a pivot to a “higher for longer” narrative? Here are bull and bear cases.
The bear case
The bear case for risk assets is easy to make. Evidence of transitory disinflation is starting to appear. Not only did the CPI report disappoint the market, core sticky price CPI, which measures slowly moving prices in the CPI basket, is ominously turning up.
As well, the Fed’s closely watch “supercore CPI” (red bars), which measures services ex-shelter, has been accelerating for the past few months.
Much like the CPI report, services, in the form of portfolio management fees and new healthcare contracts, contributed to most of the increase in PPI. These factors should ease in the coming months.
From a global perspective, the pivot in monetary policy from tightening to easing is designed to reignite growth, but it also risks the rebirth of an inflationary spiral. Reports from the U.K. and Japan show that they slipped into technical recession last week, which will renew the impetus for the BoE and BoJ to ease monetary policy.
Another little known factor that could depress bond prices further is a detail in the last Quarterly Refunding Announcement (QRA) which may not have received a lot of market attention. The U.S. Treasury projected a Q1 issuance schedule of $760 billion in paper, consisting of $420 billion in bills and $340 in coupon-bearing instruments (notes and bonds). What the market didn’t react to was the projected Q2 net issuance of $202 billion, consisting of a negative -$338 billion in bills and $540 billion in coupons. In other words, Treasury expects to redeem bills and borrow for longer maturities in Q2, and the strong supply of coupon-bearing instruments has the potential to push up bond yields.
In addition, the net redemption of Treasury Bills will have the effect of pushing up the overnight reverse repo account at the Fed, which will have the effect of withdrawing liquidity from the banking system. All else being equal, lower liquidity will create headwinds for asset prices.
The bull case
By contrast, the bull case can be summarized as “it’s only one data point”. Chicago Fed President Austan Goolsbee said at a
discussion at the Council of Foreign Relations that even if inflation comes in a bit higher for a few months, “it would still be consistent with our path back to target”.
The higher-than-expected CPI report can be mainly attributed to two factors: seasonal adjustments strength in owners’ equivalent rent (OER). Investors saw a similar upside surprise in January 2023 when the start-of-year price resets made the inflation data much worse than it seemed, but inflationary momentum faded over the course of the year. While the economists at the Bureau of Labor Statistics try very hard to make seasonal adjustments, adjustments are conditioned to the recent period of low inflation. As inflation rises, start-of-year price increases may have a non-linear interaction with inflation rates, which throws off the seasonal adjustment factor.
It is also well known that OER is a lagging inflation metric and doesn’t reflect real-time market rents. Real-time estimates of rents have been falling rapidly. An estimate of inflation using Apartment List rent rates show that headline CPI at 0.61% and core CPI at 0.78%, which are well below the Fed’s 2% target.
In addition, early signs of softness in the jobs market are starting to appear. Both initial and continuing jobless claims are bottoming and possibly seeing some upward pressure.
Gina Martin Adams at Bloomberg Intelligence also pointed out that weakness in the employment component ISM services fell below 45, which is a level that has coincided with job losses in the past.
In conclusion, I believe it’s too early to panic over one month’s inflation report. Even in the wake of the stronger-than-expected PPI report, the Cleveland Fed’s inflation nowcast shows January core PCE, which is the Fed’s preferred inflation metric, is still showing signs of deceleration at 2.7%.
The key risk to asset prices is the U.S. Treasury’s QRA Q2 projection of higher coupon issuance at the expense of bill redemption, which puts upward pressure on bond yields and withdraws liquidity from the banking system by substituting ON RRPs for bills. However, Dallas Fed President Lorie Logan, who used to run the New York Fed’s trading desk, has said that the Fed could mitigate tighter liquidity conditions by reducing the pace of quantitative tightening.
Investor focus is so much on the Fed and interest rates. ‘Higher for longer’ is due to the economy ‘stronger for longer.’ Within this stronger economy, I am seeing amazing things happen in momentum, my specialty. Momentum in all areas of investing that I watch is outperforming. Small Cap Momentum ETF DWAS outperforms the Russell 2000 Small cap Index, International Momentum ETF IMTM outperform Global International and US Momentum MTUM beats the S&P 500. D.J. Market Neutral Momentum ETF shows high momentum leading across all industries not just Tech.
This is new. Until October, momentum lagged markets consistently for the last three years as Value and Growth swung back and forth every six months and the momentum ETFs rebalanced into the new underperforming sectors at the wrong times. They zagged when they should have zigged.
But now the momentum is persisting. It would be wonderful if the outperforming company shares would be using A.I. to be more efficient than their competition. Earnings calls have been filled with talk of efficiency. We see in the tech industry layoffs after layoffs everywhere even highly profitable companies. A.I. make software easier to make. A.I. makes workflow more efficient. It targets sales better.
If more efficient company shares outperform, they could do well even if the market dips.
We could also be witnessing investors wanting to own quality leaders in all industries and not bargains that are falling because they are uncertain of the future business and consumer climate.
I have been talking up momentum for a while because I thought it would now persist. It has and I think it will continue to during these uncertain times of a better-than-expected economy.
Should we be fearing a better-than-expected economy or embracing it? I get the worry about interest rates. But really…? At least with owning momentum, you eliminate the companies that are struggling in this new A.I. world.
Ken,
I agree with your assessment. And to that I want to add the following point about Fed funds, I have seen repeated hand wringing about, Why isn’t the Fed lowering the rate without any realization of the fact that, If the economy is running as well as it is currently, and the market is reflecting that, THEN Why does the Fed needs to lower the rates? Lowering of Rates happens in a recession, or black swan events. If the economy is buzzing along with the current rate, Why should Fed be lowering it until and Unless something Bad happens? Lowering rates during Good times robs Fed. of Dry powder.
And I know people will contend that Not lowering the rate will lead to something breaking, However, that is Not currently true. If everything is humming along, then there is No reason to lower the rates. Actually, raising the rates is a possibility if the economy keeps at it as it’s going because Inflation might rear it’s head.
That is my thinking process.
Momentum investing comes with lot of caveats. I think of it more as trading strategy than long term investing. I am selectively riding this trend for now. Hopefully I can get out before the music stops.
Each and every subscription renewal these days comes with hefty price increases. Same goes for insurances – health and property in particular. Professional service providers are raising the rates as well. This speaks to me of incipient service inflation.
We have focused a lot on inflation and the fed reaction function. What is happening on the earnings level? Projected earnings growth by sector, size etc. that should be very useful in portfolio rebalancing.
“Everyone has a plan till they get punched in the mouth” – compliments of Mike Tyson.
As the saying goes there are many ways to skin a cat. Momentum Investing or Value Investing both have ardent supporters. Both work and there have been notable successful proponents who are stars in each camp – George Soros and Warren Buffett. The most difficult decision is when to sell in momentum investing. Case in point this week the darling of the momentum crowd – Super Micro Computer (SMCI) went into a free fall dropping 25.67% in one day! This is not the only stock in this hyper crazed market. At some point in time valuations, P.E. etc.. will matter. More so, now that you can get 5% in Money Market funds.
In the game of musical chairs you don’t want to be the last one standing.
SMCI just bought the San Jose site of defunct Fry’s Electronics for a price of 80MM. SMCI’s current HQ is right on the other side of I-880 diagonally. This was an electronics superstore with the interiors looking like a Mayan civilization. It was a very popular place for Silicon Valley’s techies for many years. But online shopping has forced its demise. I don’t know if this purchase is a signal or not. Th previous two, Cisco and Google, gave some signal. Cisco marked the start of Internet bubble burst and Google village signaled the start of CRE troubles but its ad business still very robust. This site has a large area of land. The founder, an old gen of Taiwanese, is a prudent man. Many Taiwanese manufacturing companies, private or public, are usually run conservatively.
I once visited a chemical company in Taiwan who currently supplies cleaning solution to TSMC’s fabs. This is very large scale operation and very high tech. They are currently into big expansion for TSMC’s new fabs. The founder is 90+ years old and still wakes up every morning to go to work, rain or shine. His company doesn’t borrow from banks and has large parcel of land purchased a long time ago reserved for expansion. Now TSMC is adding two, possibly three, large 2nm fabs in Kaohsiung, in response to chip demand from future orders for AI adoption. TSMC is also another conservative company. They are already almost done in the first phase of fab construction in Kumamoto, Kyushu. Expansion is being planned here. Another expansion is likely to happen in Osaka (some like it to be outside of Tokyo) in the near future.
In light of all these activities AI cycle is likely to continue for a while. This game has shifted from corporate competition into competition among nations. Whoever gets it done will crush the competition. At the minimum TSMC and all those large equipment providers will grow a lot of business and have much higher share prices. Two recent earnings call, Applied Material and Tokyo Electron, already give you an idea of what to come. By extension you can say similar things, at a lesser degree, about ARM, CDNS, and SNPS. These are IP and EDA shops.