Latest CPI data and its effect on Federal Reserve policy

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This article was originally published on August 14, 2022 under Tri-Macro Research.

The rise of 50 basis points from 75 basis points in September is a big standoff in the Treasuries markets. If US markets weren’t underestimating the Fed’s trajectory in 2023, I’d say ok come on 50 but the markets are discounting the cuts next year so if the fed really wants to get inflation down which i think and they said it should go 75 basis points in my opinion for set the tone against inflationary speculation in the market which has not really been brought under control.

Treasury markets are very skeptical of the Fed’s policy trajectory. Nominal and real yields will follow the data until the September meeting – which means good data, higher yields because it just increases the chances of a bigger rate hike or a persistent inflationary economy – which both lead to higher yields. Inflationary, negative real The yield scenario would also include strong data and risky assets will face rising nominal yields at some point. Inflation expectations are a component of final nominal returns. We really haven’t seen the magnitude of this in an environment where inflation is proving more persistent and Fed policy is ineffective – meaning yields haven’t risen at the same pace as the economy. so there is more catching up to do and yields would rise if the Fed were to undervalue and slowly raise rates while allowing inflation to persist.

A risk for higher yields would be recession-like data in the US which could potentially cause the Fed to pull back into a slower tightening cycle, though even then with CPI at 8%+ , I think this is not an automatic answer. I also think this scenario would not be bullish for risk assets, as earnings and corporate earnings/multiples fall as the Fed balks at lowering the fed funds rate after the latest US inflationary burst. A recession in the United States would also not depreciate the USD, as it would likely lead to lower global growth, risky currencies and commodity prices.

Dollar shorts really want to see a negative expected real return environment in the US. This would occur in a circumstance where the Fed raises rates too slowly or if the policy tightening was ineffective in bringing inflation down or in a stagflation situation. Negative expected real return environments are those where the rate of inflation expectation exceeds nominal returns. Dollar shorts want the spread between UST nominal yields and inflation expectation rates to narrow or reverse/turn negative, while the Fed wants the exact opposite. I think we’ll get the latter.

In either case of strong data or even base growth scenarios where one leads to inflation and the other goes down, yields would still rise in both cases as long as there is no severe recession in the USA. The reason for this is that the component of inflation expectations in a nominal return has completely shifted the CPI, meaning that lower inflation is already priced in by the market. Therefore, if the CPI falls, this should in theory have a negative effect close to zero on nominal returns. I know this because the equilibrium inflation expectation rate on a 10-year Treasury inflation-protected security is around 2.4% while the CPI hovers at 8.5%, well below that of the CPI.

In a real and persistent inflationary environment in the United States, the 10-year nominal yield would be at least 7% in my opinion, driven mainly by the inflation expectation component embedded in a nominal yield or interest rate. long-term interest. This makes intuitive sense because the lender wants to at least receive the expected rate of inflation over the life of the loan. We are slightly below 3% now on a 10-year UST nominal yield while the CPI is at 8.5%. Again – inflation expectations as measured by bond market participants are pricing in a significant deceleration in inflation, so if that’s the case and oil prices are falling, that’s no reason to buy US bonds in my opinion, because it has been integrated.

Markets have largely priced in the return of inflation to the Fed’s target. It’s a little ironic, but by “raising rates” it actually prevents US long-term yields from climbing much higher on the inflation expectations component – so Fed policy is to prevent stagflation. The reason for this is that a handful of 7 or 8 over 10 years with out of control inflation eroding US consumer spending would lead to a recession in real terms (lower inflation-adjusted growth accompanied by high rates of inflation known as stagflation).

I think the Fed is very aware of this risk and that is why the Federal Reserve is so determined to raise rates, even if there is collateral damage to risk asset valuations and the global economy. I think we test 4% on 10yr UST and see what breaks with the majority of the upside being driven by the real component more affected by Fed policy. Overall, I think the Fed will pull off its soft landing where inflation slows, asset prices fall, employment and consumption remain strong, although emerging market economies, currencies and stocks weaken. .

The Fed is also cutting time for China’s PBOC central bank to resolve its issues. As rising U.S. real yields due to Fed policy and a stronger dollar add to the dollar-denominated debt burden for China’s corporate sector, real estate developers have been particularly troubled. High yield could get very lousy in China to the point of deterring any consumer rebalancing on failing wealth management products, house prices, asset prices and net worth in China. At the same time, unemployment and non-performing loans from banks are soaring. Lower rates are needed there and a weaker yuan. Again, as I said above, the Chinese authorities also do not want to fuel market bubbles and they are in fact very aware of this and the effect of low rates on asset prices. So I think they’re really waiting for a more effective time to cut rates where it won’t fuel market excesses and is more of an emergency-type hard landing in response to a downturn.

On the inflation report: It really doesn’t change the Fed’s thinking other than to keep doing what it’s doing. I’ve always been in the camp for inflation to come down fairly quickly once it starts, so the initial spike isn’t unwelcome here. However, this seems to be the beginning and I think the initial bullish market reaction is way overdone. Lower oil prices are a sign of a synchronized slowdown in global growth which I believe is just beginning and is not bullish for stocks or risk assets. Everyone knew the headlines would slow down simply because of lower oil prices in July, so it’s really no surprise. The month/month base, which is arguably the most important figure, remained firm at a 0.3% rise after a very large 0.7% rise the previous month. Does this report favor a 50 basis point hike rather than a 75 basis point hike at the next meeting? Absolutely not in my opinion, because the Fed will not want to undervalue or even simply meet market expectations. This would only ease the financial conditions. The Fed wants to tighten, which I think means going back to 75 basis points at the next meeting, whether the market fully anticipates it or not.

For example, the market expects a rise of 50 basis points in September. If the Fed were to hit 25 basis points or even 50 basis points, it could have the opposite effect predicted on financial market conditions and thus fail to control inflation or even fuel it higher. Financial market conditions largely reflect nominal and real bond yields, equity prices, the value in USD versus other currencies, and credit spreads between risky and risk-free bonds, where tighter spreads mean lower spreads. looser conditions and wider gaps mean tighter conditions.

This is important because financial market conditions are one of the ways that monetary policy feeds into the real economy. So, if the Fed is serious about tightening financial market conditions and lowering inflation, it must exceed market expectations for interest rates. Otherwise, the effects are canceled because the market is already pricing in a 50 basis point rise in September. The Fed needs to move to 75 if it wants to have a tightening effect and a continued deceleration in the CPI.

About Meredith Campagna

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