Financial markets got a shot in the arm in the first two weeks of August, as they digested the first round of positive news on the inflation front since the Federal Reserve began to tighten monetary policy in March of this year. On August 1, the July ISM (Institute of Supply Management) Manufacturing Prices Paid Index reading was released. It fell to 60 in July down from 78.5 in June — the lowest reading since August 2020. The Prices Paid Index, a sub-index of the larger PMI (Purchasing Manager Index) Survey, is an indicator used to gauge the degree of inflationary pressures in the economy. Many interpreted the drop as indicative that supply chain constraints were easing. In addition, July Headline CPI (Consumer Price Index) moderated more than the 8.7% forecast, increasing by only 8.5% on a year-over-year basis, decelerating from 9.1% in June. PPI (Producer Price Index), considered a leading measure for consumer inflation, also increased less than forecast in July coming in at 9.8% versus expectation of 10.4%, slowing from 11.3% in June. On a month-over-month basis, PPI contracted 0.5%, with consensus expecting an increase of 0.2%.
Inflation coming off the nosebleed levels of the last few months, which marked 40+ year highs, spurred talk of peak inflation and generated hopes the Federal Reserve could pivot to a more dovish stance on monetary policy. Recent data on the inflation front is a welcome sight and it may factor into the Fed’s calculus in the form of a 50bps (basis point) rate hike in September rather than the 75bps hike bond markets were pricing in at the end of July. That said, the Fed will likely want more evidence that inflation is moving back to target before taking their foot off the gas in any meaningful way. At the same time, there is a growing body of evidence that the economy — and more specifically the U.S. consumer — is weakening. Not the least of which is the two most recent quarters of negative GDP growth. Headline CPI decelerated but Core CPI, which strips out food and energy, came in lower than consensus but accelerated from 5.7% to 5.9%. The “stickier” components of inflation, such as shelter costs, are continuing to rise and labor markets are red hot by just about any measure and as a result wage growth and labor costs will likely continue to exert upward pressure on prices. Even with the better-than-expected news on the inflation front, the Fed remains in a sticky situation.
For those paying close attention to U.S. Treasury markets, the moderation in CPI and PPI was probably not a great surprise given the TIPS (Treasury Inflation Protected Securities) market has been telegraphing decelerating inflation for several months. TIPS breakevens, which represent a market implied measure of inflation expectations, peaked at the end of the first quarter (Q1). In addition, a Fed-preferred measure of inflation expectations, the 5-Year/5-Year Forward Breakeven rate, has also been falling in recent weeks. While it remains to be seen if we have, in fact, seen peak inflation, it appears the bond market might have called it correctly based on recent inflation data. However, if the bond market is to be believed on inflation, one can also not ignore the current inversion in the nominal yield curve which would seem to indicate that while inflation might be slowing, the Federal Reserve is still in a sticky situation as it relates to recession. Unfortunately, the yield curve inversion — one of the deepest in recent memory as measured by the 2s-10s (the difference between the 10-year Treasury yield and the 2-year Treasury yield) nominal spread — has a strong predictive history of preceding recession. It seems to be an indication the blunt tools at the Fed’s disposal might bring down inflation/demand but are also likely to continue to have a significant impact on growth.
Fixed income markets could certainly use some relief from the inflation-induced volatility we have seen year to date. As of August 1, 2022, U.S. Treasuries were down 7.19%, U.S. Investment Grade Corporates were down a whopping 11.07% and Tax-Exempt Municipals are on pace for the worst year since the early 1980s down 6.62%. For higher-grade bond markets, more insulated from credit risk, the building recession concerns heading into year-end could provide a small silver lining in the form of more stable interest rates as fears of recession tend to push rates down counteracting the pull up from concerns over inflation. That said, along with negative returns across financial markets due to higher rates themselves as a function of higher inflation, the burden placed on American households is sky high.
Inflation is starting to create some concerns in the most important areas of the economy. Consumer spending has shown extraordinary resilience in the face of higher inflation over the course of this year. While the first read of Q2 GDP indicated the U.S. economy had contracted 0.9%, personal consumption, up 1%, was one of the few areas of the economy that provided a positive contribution. A positive contribution from personal consumption for Q2 is certainly better than the alternative, but still less than half of the 2.1% average increase for the three-quarter period preceding Q2 2022. Consumer sentiment, while improving, remains near record lows touched in July. Given the U.S. consumer accounts for approximately 65% to 70% of GDP: so goes the consumer, so goes the U.S. economy. Recent data would also seem to indicate consumer balance sheets are weakening. Consumer credit card balances surged in June, increasing $40 billion versus expectations of $27 billion. As of August 1, 13% of American households, year to date, have spent more than they have earned as they grapple with higher prices in all aspects of life. Finally, personal savings as a percentage of disposable income continues to fall coming in at 5.1% in June lower than the 8% average post-2008 and well behind the 12.5% post-COVID.
The impact tighter monetary policy is having on the broader economy is certainly not lost on the Fed; the U.S. housing market is a prime example. With mortgage rates touching 6% in mid-June, the highest level since late 2008, it should not come as a surprise that existing home sales are down 14% on a year-over-year basis.
The unfortunate reality for the Fed is that the alternative to demand destruction — unanchored inflation expectations and an extended period of nosebleed inflation — is likely more destructive in the long run than the current damage being done to the economy.
Fed officials have been very clear in their messaging on this point. The Fed is in the unenviable position of trying to balance a teeter totter — putting enough pressure on inflation via tighter monetary policy to reign it in but not so much that they send the economy into a tailspin. There has not been a tightening cycle in recent memory that did not end with the Fed Funds rate above the prevailing rate of inflation. After the 75bps hike in July, the Fed Funds rate sits at 2.25–2.5%, woefully short of even current Core CPI, which is just shy of 6%. The Fed moved away from forward guidance at their last meeting to a stance of data dependency. This creates a vacuum of information that can be filled with optimism that the Fed may slow the pace of hikes but is also an implicit admission that they don’t know when they will be done tightening policy. In the last weeks, several Fed officials have also sent a clear and consistent message that markets should not expect much slowing from the Fed anytime soon. The adage “Don’t fight the Fed” comes to mind. Recent inflation data is reassuring and an indication that inflation can be tamed, but investors should expect more Fed-induced volatility as they are likely far from done.
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