by Hubert Marleau, Market Economist, Palos Management
May 17, 2024
While macro factors like growth, demand for safe assets and supply of government debt all play on 10-year Treasury yields, investors should not downplay the colossal impact on them exerted by inflation,which dictates what matters when it comes to how capital is priced and allocated.
Federal Reserve Chair Jerome Powell said on Tuesday last that he saw inflation retreating in the coming months. He pushed back on the expectation that the central bankâs next move would be to raise interest rates yet again, but believed that it would hold the policy rate as its current 5.38% for as long as it took to drive inflation down to their 2% target. The question then asked by investors is whether the current level of interest rates is working to the extent of weighing heavily enough on consumer spending to reduce inflation.
Last week, the data docket was filled with new data on both actual and expected inflation.
It started with surveys conducted by the University of Michigan, as well as those of the New York and Cleveland Feds, all foreshadowing much higher inflation in the next 12 months today than they did even a month ago. Their readings of 1-year ahead inflation ranged from 3.3% to 3.8%, roughly 0.3% higher than they were then. However, the savants of the bond markets held a significantly different view of where it was heading, predicting only 2.25%. They did not express the same inquietude as consumers and business that inflation was getting out of control.
The BLSâ reports on wholesale and consumer inflation proved the latter right. At first glance, the April 0.5% m/m increase in both the headline and core producer price index (PPI) look awful because the expectation had been only 0.3% and 0.2% respectively. The jump was not as bad as it appeared, because it sprang from a sharp downward revision in the March print from 0.2% to -0.1%, and from the fact that the PPI final demand for personal consumption was flat, helping balance things out. As a matter of fact, the latest NFIB Small Business Survey suggests that price pressures are softening, as fewer firms are planning to increase selling prices, stating that poor sales was a more important problem.
As it turned out, the April retail sales were unchanged from March; and by stripping away spending at car dealers and on gasoline, retail sales actually fell by 0.1%. In addition, of the 13 main business categories tracked by the Commerce Department, 7 showed negative figures, illustrating that households had tightened their belts on discretionary items and were concentrating on necessities instead.
Walmart, for example, reported that the average bill at the cash register had been flat but that the number of transactions had risen in the April quarter, occasioned by more visits to stores, driven in turn by purchasing less costly items and price advantage against rivals. This makes sense because consumers have depleted their excess savings from pandemic years and more of them are missing payments on credit cards and auto loans. From here on, household spending will likely only follow increases in disposable income. Only retired baby boomers are spending like drunken sailors.
The pullback in consumer demand brought about a much awaited reduction in the Atlanta Fed NowCasting GDP growth estimate for Q2 to 3.6% from 4.2%, and confirmation, along with leading indicators, that inflation is still moving in the desired direction toward the Fedâs 2% target, after backsliding in Q1.
Meanwhile, the monthly pace of headline inflation slowed more than expected bringing the y/y increase in the Consumer Price Index (CPI) to 3.4% in April from 3.5% in March. There was plenty of room for optimism for this trend of disinflation. Core prices for goods registered an outright decline of 0.1%, while core services prices rose by 0.4%, the lowest since December. Moreover, CPI ex-shelter was up only 2.2% y/y. Take note that both rent of primary residences and ownersâ equivalent rents continued to disinflate in April as did oil prices - an important psychological indicator of inflation expectations - which touched a 9-week low at 78.00 for a 7.0% decline.
This situation did not merely take the tail risk of rate hikes off the table. For example, the swap market on government bonds is predicting that the personal consumption expenditure deflator (PCED) would be up 2.1% next April. Accordingly, odds of a September rate cut were up a cool 75% on Wednesday afternoon, from 45% just a month ago. The chances are not high enough to put a rate cut on the table for September, but are nonetheless high enough to alleviate concerns that the Fed may not cut at all this year.
For the former to happen the job market needs to be cooler. This is happenning, but slowly, initial jobless claims continue to hover near 200,000. Indeed the bond market sold off on Thursday and Friday, generating a more hawkish pricing in the swaps market for future Fed funds rates.
The bottom line, however, is straightforward: the economy is cooling down, but chugging along in âno landingâ territory. Eager to deploy some of the towering $6 trillion investors have in money market accounts, the S&P 500 rallied to a new record high on Wednesday to 5308, ending the week at 5303, up1.5% from the previous Friday.
In conclusion, central bankers, in the last mile of their battle against inflation, still need labour markets to cool, though the impact on unemployment may vary across countries. Thatâs according to a new analysis by formerFederal Reserve Chair Ben Bernanke and former International Economist Oliver Blanchard, who undertook the research for the Peterson Institute for International Economics in a joint project with no less than ten major central banks, including the Bank of Canada (courtesy of Bloomberg). In order to bring back inflation back to target, along with a better balance in labour markets, a reduction in vacancy-unemployment ratios is very likely needed.
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