By Robert P. Balan :
Rising inflation is still in our future
While deflation and negative interest rates dominate headlines, the January CPI rose sharply forcing investors and the Federal Reserve to take another look at their inflation projections once again. For January 2016, Core CPI rose to 2.22% yoy (the largest gain in 4 and a half years), up 2.29% on a semi-annual basis, 2.54% on a quarterly basis, and +0.29% month-on-month, higher than the +0.20 expectations. On annualized basis, January's 3.571% month-to-month was the strongest number since March 2006. Indeed, core CPI is accelerating as we have expected, and we could even make a case that it will accelerate further. This may come as a surprise to some investors, who may have had their minds conditioned that this cannot happen with falling energy prices and with a strong US Dollar, which translates into cheaper imported goods. But the simple fact is that US core inflation, from a micro point of view, is principally driven by the cost of services, as well as labor inflation at present (see chart below).
As early as the middle of last year, we began highlighting the strong upward move of US shelter costs which have been pushing up core CPI. But with the January CPI data it became clear that CPI-Shelter is no longer alone as core inflation driver. Now, education, medical care, and rent are all rising briskly as well. CPI-Shelter made a new post-recession high in January, but the big move higher last month had been driven by medical care inflation. That effectively equalized the deflation that was going on in core goods. The January data is probably indicating to us that the sideways move in medical care inflation in the past several months is history, and henceforth will continue to trend higher (see chart below).
Observers may note that the Fed prefers the PCE as its gauge of inflation, and PCE is still lower than PCI at this time. But since medical care was a big driver in this month's CPI report, it simply means that the core PCE report coming out this week could be even be more impressive that Core CPI. Medical care has a much larger weight in core PCE. This was the reason why core PCE had been weaker than core CPI since last year, but that has changed. On the other hand, core goods prices are still hamstrung by the recent strength of the US Dollar, and therefore are unlikely to ratchet suddenly higher. The impact of previous US Dollar strength still continues to reverberate, and that will weigh down on core goods prices for a little longer (see chart below). The core goods part of CPI has been under the radar since late 2013, and has become less crucial and less relevant (except as drag to the other core sectors). But with the outlook for services (driven by housing, education and medical care) still to reach its full potential, the drag from core goods will not matter soon.
Inflation expectations and bond yields are bottoming
The broad underpinnings of the January CPI data confirms that the reality of higher inflation will remain a game-maker in our near-future. The notion that deflation is THE existential threat, and that the powers-that-be are helpless to combat it, may become a critical miscalculation of the market. We believe that inflation is headed higher, whether investors expect it or not. Inflation has been trending below the Federal Reserve's target of 2.0% for the past four years (see chart below), a fact that has conditioned our minds to expect low and slow growth -- low inflation had suggested weak demand growth and had raised fears of actual decline in prices, or deflation.
However, it was the headline CPI not Core, which bore the sharp decline in energy and food commodity prices. The very weak headline CPI, hammered by the strength of the US Dollar, helped shaped our current expectations of low inflation which would stay for some time. Those expectations will soon collide with the reality of resurgent inflation pressures as core inflation rises over the rest of the year. Moreover, the rise in the core will soon be abetted by the energy-and-food-heavy Headline CPI which is starting to build a head of steam, as consequence of the US Dollar's recent weakness (see chart below).
There is this meme that low commodity prices and the strong US Dollar will keep inflation expectations low in the foreseeable future. That had significant impact in the pricing of major financial assets, especially bonds. Inflation expectations premium is probably the most significant component of bond prices -- the lower expectations are, the lower bond yields are expected to go -- inflation expectations and bond yields are positively correlated. Declining inflation expectations have been a key motive force for falling yields in the past two quarters, more specifically since early January this year (see chart below). And falling inflation expectations have been driven in the past year by the sharp decline in the rate of actual Headline inflation. Just to be clear, inflation expectations do not drive actual inflation -- it is the other way around -- actual inflation drives inflation expectations.
But the conditions which begot falling inflation and inflation expectations, are now reversing -- commodity prices (in general) have stabilized, with the yoy rate of change starting to rise. And the US Dollar has weakened significantly in the past several weeks. So it is not a surprise at all that inflation expectations (breakevens) have shown signs of reversing as well in recent days. These developments could have significant implications -- higher inflation and inflation expectations, firmer commodity prices, and US dollar weakness may be telling us that bond yields would have the wherewithal to post a bottom soon (see chart below). Of this mix, the most important variable to watch is the high-frequency (1Q) change-rate of the US Dollar TWI -- it has a lead of two weeks over the rest of the variables.
The Fed may be vindicated for tightening policy in December
The sharp rise in Core CPI in January came at a critical time. The Federal Reserve (which is perennially accused of being "behind the curve"), for once, was accused of being "much ahead of the curve", and that it tightened monetary policy in December even in the face of domestic and global growth headwinds during a period when inflation was not the problem, and that deflation was (see chart below). The Fed in response had said that they expect inflation to rise towards their target in due time, hence the SEP dots reflected several rate hikes over the course of 2016, with the next hike expected in March (see Fed inflation expectations, three charts previous) . Fed Chair Janet Yellen even told Congress during her annual testimony that she expects prices would rise over the medium term in the US. But after global markets swooned early in the year, the Federal Reserve started to move away from the expectation that they could tighten in March.
However, the January CPI is a strong and ominous signal that the broad inflation picture is rising and may in fact even accelerate over the rest of the year, just as the Fed feared it would. That March possibility has just landed squarely again on two feet - a March tightening could be back on the table. What exacerbates the Fed's predicament is that all the classic, underlying fundamental drivers of core inflation are showing that indeed, the odds favor further gains in the core. In the chart below, the classic drivers, e.g., M2 money velocity rate-of-change, bank credit growth, and recent GDP growth are combining to give Core CPI a strong boost until at least Q1 2017 (see chart below).
The collective impact of all these factors are showing up in diverse data such as in the Core CPI-Services and in the CPI - Housing and Rents. Moreover, if commodity prices stop declining, and if the US Dollar's continues to weaken, then Core Goods CPI will cease to become a drag. That may set up for the Core CPI a "perfect storm" of several combined factors which will make it soar in a degree that nobody has expected.
This buzz will become even stronger when core PCE "surprises" higher this week. We expect a pickup in the core PCE to 1.65% year-on-year, which if confirmed would be the highest PCE has risen to since September 2014. These inflation developments may even become the key argument of hawks on the FOMC that want to see multiple hikes this year. Be that as it may, a March tightening may be a quarter too soon in our opinion, as the global markets are still struggling to find a bottom. The global market woes have been exacerbated by a strong US Dollar, which has been bid over the past several quarters, fueled by the Fed's barely concealed desire to tighten policy. Another tightening move too soon could reignite another strong US Dollar rally that would put the global markets back into crisis mode and negatively impact US growth as well (see chart below).
A USD resurgence will come at a bad time as the US final GDP for Q4 2015 will likely be not much above zero percent. We believe that the Fed will have an idea about those dismal numbers by the time they convene on March 16. If the Fed finally decides to make a follow-through to the December hike, we believe they would do it in June.
Higher inflation, firmer growth will force bond yields to rise soon
These inflation developments, when coupled with the apparent market under-estimation of US growth in Q1 2016, will likely have a profound impact on the bond market in the very near term. The bond market currently sees very low inflation and growth prospects for H1 2016. The 10 year bond yield fell to as low as 1.52% last week, and was trading at 1.7450% at Friday's close. With core inflation coming in at 2.8% in a year if current growth rate is sustained, and with Q1 2016 quarterly GDP growth at 2.75% (based on Atlanta GDP Nowcast trend, see chart below), there exist a wide divergence between the 10 year bond yield level and the level of growth implied by those two rising variables.
The market-implied GDP growth rate based on the benchmark 10 year Treasury yield at last week's close was a contraction of 1.55% during Q1 2016. That is far below the 2.75% growth that the Atlanta Fed is projecting. Working back based on historical relationship, the 10 year yield should be at 2.35% rather than last week's 1.7450% close (see chart below). That is at least a 55 basis point spread between the market's current growth assessment and the Atlanta Fed's projections. The 10 year yield and the Atlanta Fed's GDP forecasts have had good correlations in the past (directional-wise), but they diverged sharply in early January. that was when the turmoil in the global asset markets started, which triggered a flight to quality, contributing to the sharp fall in bond yields over the past few weeks, creating the divergence.
The economy grows in Q1 2016; the labor market is still robust
We believe that the Atlanta Fed's case for growth in Q1 2016 is solid given that jobless claims hit a three-month low last week; industrial production rose for the first time since July; and consumer spending, rose in 2015 at its fastest pace since 2005. An adjustment is highly possible in interest rate markets expectations over the next few months, and we expect that the 55 basis point divergence will close rapidly, as bond yields ratchet higher. The general US economic situation was summarized by Boston Fed President Eric Rosengren, when he said last week:
"Turning to the national economy, in December the FOMC raised short-term rates for the first time since the financial crisis, by a quarter of a point. That decision reflected further improvement in a range of recent labor market indicators, confirming that under-utilization of labor resources has diminished -- and the Committee's expectation that inflation will return to 2 percent, the inflation target set by the Federal Reserve, over the medium term."
The US job situation remains robust as well. The sharp rise in the quit rate to its highest level since the Great Financial Recession (GFC) recovery in Q1 2009, and the fact that there are more job openings than actual hires, suggests to us that the labor market still has a lot of room to grow. When the quit rate is low, it means that many people who would have left their jobs in a more normal labor market stayed at their jobs because they were worried about finding a new one. That there is now a quicker turn-over in job changes tells us that there remains sizeable potential for the labor market to create new jobs (see chart above).
RISK ON-RISK OFF models: short-term pain, long-term gains
This possibility is in fact being flagged by our Risk-On, Risk-Off models (see next two charts, below). These proprietary models have been running since 2006, and were re-calibrated in 2009 to incorporate the lessons of, and data skew brought about by, the Great Recession of 2008. These models are liquidity-driven. In September last year, we decided to introduce some parametric changes and put the models up at my Seeking Alpha blog for an extended out-of-sample validation. If you are interested in seeing the evolution of these models since then, please start here.
Our Risk On, Risk Off models are suggesting that the current mini-Risk-Off phase may be over very soon. The further implication of the first chart is that the blood-letting in the market may not be over yet -- another Risk-On episode is due soon, and it could last until the middle-third week of March. But a larger Risk-Off phase should follow thereafter. The scale of the next Risk-Off phase, being shown by the models, tells us that a March inflection point may the end of a significant market down cycle. Initial readings show that the next Risk-Off period could extend to late June. For the latest update, please go here .
The second chart (below) show that the way large commercial banks hedge their asset balances can provide long leads on trends of bank lending and even domestic growth. The hedging imperatives create de facto forecasts of credit and growth trends. GDP growth is a summary of myriads of transactions that are performed in all the markets of an economy, where many if not most of these transactions are facilitated by credit. It is a short leap of faith therefore to make a connection between the changes in the banks' credit creation (as reflected by their asset balance hedging behavior) and the changes we see in GDP growth.
The third chart (below) shows that NIPA profits have started to decline, and will likely continue to do so until end of Q2 2016. The period encompassing H1 2016, will be an unfriendly one for NIPA profits. But H2 will probably a better environment for NIPA profits and the Dow Jones Ind Average, which has born the brunt of risk-off phase since mid-2015.
There are more details on this RO-RO indicator here.
We believe that the most pertinent implications of the forthcoming major Risk-On phase are as follow:
- Bond yields will likely rise significantly higher to adjust to the levels implied by stronger inflation and US GDP growth over the near-term. We expect the 10 yr yield to see th 2.35% level again, at least. This is our projection of an expected adjustment in 10yr yield levels: see it here (note: this is a live link ; it is updated as new data comes in).
- We should also see a significant (cycle-degree) bottom in the equity markets by the end of Q1. We expect the S&P 500 to test the 2130 area resistance on or just before the year is over: see the expected evolution of SPY here (live link).
- With a large, upside adjustment in bond yields, the US Dollar will probably launch another rally, which could make new highs in the USD trade-weighted index. See the expected evolution of the USD TWI here (live link).
- Gold may therefore likely suffer a correction, but given its recent huge gains, Gold may hold substantially above the previous $1051 low. It will surprise us if gold bullion price will fall below the $1040 level in a major retracement phase. See the expected evolution of Gold Bullion here (live link).
- Commodities could again be pulled in opposite directions by the implications of growth, higher inflation, and a general risk-off phase on one side, and a stronger US Dollar, on the other. See the expected evolution of Brent oil priceshere (live link).
- A Chinese growth surprise, if it comes, could also help prime a new cyclical Risk-On phase by mid-year. This is a very wild card, but if it does happen, market sentiment will reset on very positive mode. See the evolution of China's growth factors here (live link).
We do not discount a surprise development in Chinese growth going into H2 2016. The factors that normally power domestic growth have been going full blast for 5 to 6 quarters now (see chart below), and we feel that China's GDP could move off the floor that it has been lying on for the past quarters. The increment need not be big -- as long as it is a positive surprise, the market will leverage asset prices off it higher.
The combination of growth and higher inflation should be good for commodities, and the only fly-in-the-ointment is that a sharp readjustment of bond yield higher should also push the US Dollar exchange rate valuation higher against other major currencies. That would not normally be beneficial to commodities, especially for gold, which has been rising sharply on safe haven, weak Dollar, low interest rate tailwinds of late. The price of gold , which had soared in the last few weeks (and could still make inroads higher in the short-term), may significantly retrace in the event of a new USD bull phase.
Nonetheless, we also saw recently that the Dollar-commodities relationship can be put on hold during "special factors" environment, so a revaluation of the US Dollar in the near term may not necessarily impact commodities severely this time around. But if China growth fundamentals also do improve by Q2 2016, then commodities can still significantly move ahead even during a period when the US dollar is trending higher.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.