Market & Economics explainer series : What next for inflation? why the deviation in perception of common ppl, the Fed and the market about it ? Why market think Fed is wrong.
Inflation is currently the single most important focus in the market, the future trends of inflation is what makes/break the market now. With all the chatter about inflation, why is market participant complaining about fed current inflation crusade ? To understand why, we have to look at various inflation data, and leading inflation indicators.
The inflation perception of each group be sum up as follows and into the following 2 charts,
1) Commoners ( everyday folks including myself ) : CPI yoy of 8% is far too high !
2) Central bank ( especially federal reserve ) : core PCE +/- 4.6% shoots above the 2% target
3) Market ( based on various forward looking data ) – What inflation !?? Fed is fighting yesteryear battle and causing pain to both wall street & main street. Their outlook is summarized in 5 years TIPS breakeven rate.
<CPI, PCE, TIPS>
<5Y 10Y breakeven rate>
Common ppl ( including myself ) perception
Phase 1 ( 4Q 2022 to 2021 )
Inflation had been raging, the everyday joe that you encounter on the street is lamenting about the inflation( I felt & emphatized with their pain, the pain of inflation has been deeply felt in my pocket as well ), most of them will invariably say it’s because of pandemic induced supply chain issues, high crude oil and commodity price, fed printing money, etc. etc, all of which are true.
Phase 2 ( 2022 )
In 2Q and 3Q 2022, there is a split in opinion among this group. Some are still complaining about inflation, but some of them start to realize price is moderating, especially those who pump gas and pay close attention to their grocery and shopping bill.
Federal Reserve perception
When everyone started lamenting about start of price increase and the uptick in inflation in mid 2021, Federal reserve is saying nope, inflation is transitory. And in 1Q 2022, they hint at inflation coming in higher than expected ( well duuhhh !! ). In 2Q 2022, they finally started waking up to their late “pants on fire” scenario. In Jackson Hole symposium, Powell deliver his (in)famous speech by invoking past Fed chair Volcker and wow to keep at it, even at the expense of causing pain to some household. And in the most recent 2 weeks ( Sept 26th to Oct 8th ), they scheduled more than 30 fed members speech on their seriousness to fight ( yesterday ) battle.
By the way, with a core PCE of 4.7, it is how the Fed arrive at terminal rate projection of 4.5% fed funds rate in their September fed meeting SEP(summary of economics projection ) publications.
Market perception
Market perception can be divided into the following phases,
Phase 1 ( 2Q 2020 – 4Q 2020)
While everyone is beaten down by the pandemic losses in 2020, market was saying: “ look out ! inflation problem is looming. “ few take heed ( market , logistics, manufacturing and commodity sales ) and no attention was given by Federal reserve.
Phase 2 ( post pandemic 2021)
When inflation start accelerating and show signs of becoming rampant in 1H 2021 , more people start taking heed ( everyday folks, market, logistics, manufacturing and commodity sales ) , while fed is brushing it off by saying it is transitory.
Phase 3( 2022 )
While market was initially concern about the next bout of rising price again at the start of Russian invasion of Ukraine, market was also very quick in sussing out the true future inflation signal subsequently. ( drop in raw material prices, freight ) thus the breakeven rate has been falling.
The wide deviation in perception is because Market is forward looking while fed is looking at the lagging pricing.
<ISM price>
Market is looking at raw material prices, crude oil, manufacturing paid prices used car sales data, housing prices and arrive at the conclusion that inflation battle is almost over. The ISM price paid from 1999 till 2022 shows ISM manufacturing price trend lead the CPI trend every time, and this is why market believe the turn in inflation is coming.
Problem is fed doesn’t look at those leading data and is still looking at backward data, which is price & rate of increment over the previous 12 months.
This is why market has been pricing in pivot in end June – august period ( and fall apart during Jackson hole speech ).
<BOFA financial conditions indicator>
As shown in the chart, given by BOFA, because fed Is hiking when inflation is retreating and growth concern is escalating, the financial condition has been too tight and is approaching peak tightness level, almost at 2001, 2008 tight liquidity level. Will something break then ? ( if Fed is too obstinate about the yesterday inflation battle even when figure has shown mark slow down, then maybe it will break the market in a big way )
Market believe the cracks are showing up because the ISM manufacturing PMI has been slowing sharply to 50.9 in most recent readings ,
<ISM manufacturing PMI>
For entire ISM PMI report summary pls go to the following link.
https://www.prnewswire.com/news-releases/manufacturing-pmi-at-50-9-september-2022-manufacturing-ism-report-on-business-301638361.html
When will the CPI data start reflecting the downturn ? Some sophisticated market participant believe it should soon, maybe in the next 1 -3 months. Once inflation roll over, it will be a excellent entry point to buy stock again.
Stay tune for further update on US markets and economy
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