While investors know Fed wants inflation "deader than dead", metric is not entirely clear. While not singular, Volcker finally ended "war" when 3M annualized CPI fell to 2.5%

After many conversations with clients since the Sept FOMC (9/21), our overarching takeaways are the following:

  • Fed sole focus is quashing inflation and
  • In a way to make sure inflation is “deader than dead”
  • How this is measured is not entirely clear
  • Investors have lost faith in economists’ models/projections on inflation
  • Fed similarly has little confidence in models and wants to see “tangible results”
  • Because of known and variable lags, plus market impatience
  • This is read to mean Fed will push US into a recession
  • Hence, risk assets sell off and yield curves invert

There are “greenshoots”

Stocks have been caught in a painful downtrend for most of 2022 as the Fed is fighting the war on inflation. But we think there are other paths to beating inflation beyond creating a deep recession (which Fed is willing to move towards). In this commentary, we highlight a few perspectives:

  • While markets viewed Fed commentary as drastically more hawkish, Fed funds futures only increased by a single hike for 2023.
  • Granted, this could worsen if inflation data worsens, the key is that inflation trends remains the primary driver
  • One of his more notable comments (Powell) is the lack of progress on 3M, 6M and 12M inflation
  • We looked at the 1970-1982 battle on inflation, and an interesting data point is Volcker ended the war on inflation when headline CPI 3M annualized fell to 2.5% (cycle low)
  • In the 2022 context, this level will be seen in 2023 — does this mean this could be an important metric?
  • More importantly, Fed funds will exceed 6M annualized inflation sometime in the next 4 weeks — monetary rates cross into truly restrictive territory now
  • Costco and Fedex recent comments talk of significant disinflation
  • Since 1948, whenever ISM “% reporting lower prices” exceeds 10%, PPI has tanked
  • The most recent figure was 27%, well above the 70-year average of 10%
  • The latest Manheim Used Car index shows used car prices now falling at a -50% annualized rate
  • Yup, goods inflation is looking “transitory”
  • Fed focus is cooling inflation in labor markets and cooling services (sticky) primary of these being housing

RESTRICTIVE RATES: Fed funds becoming restrictive vs CPI (6M) this month

We have heard many investors say monetary policy is too low because “CPI is 8% but Fed Funds is only 3.25%”

  • but this is misleading
  • investors should consider forward CPI and forward rates
  • not “backwards looking” YoY CPI
  • the better perspective is to look at 6M annualized CPI versus Fed Funds
  • this is arguably a better measure of forward cost of money
  • using swaps markets, we see that Fed funds will soon exceed forward CPI
  • this crossover is expected to be in the next 4 weeks
  • peak restrictive rates is December 2022 (see below)
  • hence, we believe further impacts of tigher monetary policy will soon be felt
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%

New FOMC dot plots show Fed front loads rate hikes, and 1 hike in 2023

Using the Fed’s Summary Economic Projections, the median shows the following:

  • current Fed funds 3.25%
  • FOMC SEP Fed funds by YE 2022 4.40% +1.15%, or 4-5 hikes Nov/Dec
  • FOMC SEP Fed funds by YE 2023 4.60% +20bp, or 1 hike

FOMC SEP: Summary Economic Projections September 21, 2021

While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%
Source: FOMC

Market-based Fed Futures: post-FOMC, +1 incremental hike in 2022 and +1 incremental hike in 2023

While investors talk about markets having a sharp reaction, post-Sept FOMC, the peak Fed funds rate for 2023 moved up by only 20bp:

  • pre-Sept FOMC, May 2023 FF was 4.48%
  • post-Sept FOMC, May 2023 FF now 4.67%
  • Or +21bp, or 1 hike
  • this is 67bp higher than pre-August CPI
  • August CPI changed market perceptions around peak Fed hikes
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%

And as shown below, Fed fund futures show investors expect the Fed to raise by about 50bp in 2023:

  • FF futures show +50bp roughly of hikes in 2023
  • For investors, this makes them wonder if the Fed is overly front loading hikes
  • If inflation continues to surge, then 50bp is not a lot of wiggle room for the Fed
  • Thus, some investors think the terminal rate of Fed of 4.6% is too low
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%

Fed noted little progress on inflation

The Fed noted that there has been little progress on inflation in the Sept FOMC press conference. And this statement below was notable to me:

  • The Fed has not made entirely clear what metric will be used to measure progress against inflation
  • They want to see consistent and measurable progress
  • So many economists view this as 2-3 improving CPI reports
  • But Powell’s comments offer another intuitive way to see progress on inflation
  • is consider 3M, 6M and 12M inflation
  • in 2022, these are all still running too high
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%
Source: FOMC

LESS FUTURE INFLATION: Compared to post-June FOMC, market-based inflation -100bp less in 2023

While this comment by Powell is certainly true, the inflation swaps markets are showing progress in the past 3 months:

  • December 2022 forecasted inflation, using swaps market is now 6.6% versus 7.6% post-June FOMC
  • June 2023 inflation is now forecast to be 2.5% compared to 3.7% post-June FOMC
  • The improvement in forecasted inflation 120bp for June 2023
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%

VOLCKER: War on inflation ended when 3M annualized CPI fell to 2.5%

When looking at the 1982 period, when then Fed chair Volcker ended the inflation war, the Fed chair first postulated ending the war in October 1982:

  • by 1982, YoY CPI had fallen to 5% from 18%
  • the 3M annualized inflation was down to 2.5%
  • so the “leading edge” was showing far greater progress
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%

In fact, the 2.5% annualized rate by October 1982 was the lowest in a decade.

  • it was 2.5% in 1976 (and Burns saw this as a victory)
  • but the YoY was still >7%
  • So in a way, 2.5% 3M annualized CPI is a notable metric
  • inflation after October 1982 continued to fall
  • but this was not known in October 1982
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%

2022: 3M annualized CPI might fall to 2.5% sometime between September 2022 and Dec 2023

Taking this to today, our data science team looked at forward inflation forecasts (using swaps markets) and this is shown below:

  • 3M annualized CPI might fall below 2.5% between Sept 2022 and Dec 2023
  • The YoY is expected to be below 3% by YE 2023
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%

PRODUCER DISINFLATION: Evidence PPI disinflation started August 2022

And incoming data points and anecdotes point to slowing inflation. Take a look at the comments from Costco ( COST 0.08% ) and FedEx ( FDX 0.65% ). These were shared by Vital Knowledge:

  • Costco notes there are signs their buyers (purchasing agents) are seeing examples of prices coming down
  • Fedex noted rates also dropped meaningfully in the last two weeks
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%
Source: Vital Knowledge

In fact, the comments from  COST 0.08%  and  FDX 0.65%  corroborates what was seen in the ISM surveys:

  • the % respondents reporting lower prices surged to 26.7%, or > one quarter
  • the 70-year average is 10%
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%

Since 1948, every surge in “% lower prices” >10% is followed by a massive drop in PPI

Since 1948, every surge in “% lower prices” >10% has led to a steep downturn in PPI (producer price indices):

  • take a look below
  • the most comparable PPI period is 1975
  • and see the huge drop in PPI?
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%

TRANSITORY: Used car prices now falling at 50% annualized rate

The latest Manheim index shows Sept mid-month prices fell 2% and Manheim notes weakness should continue to the end of the month:

  • 2% over 2 weeks is 4% monthly
  • of -50% annualized
  • this is a massive downward acceleration of the price declines of used cars
  • this is showing many “goods” inflation was transitory
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%
Source: Cox Automotive

As shown below, the surge in used car prices, which had a huge impact on CPI, is now turning into deflation:

  • the decline is looking symmetric
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%

USED CAR CPI: Interstingly, used car CPI is not yet showing any fall in use car prices

Interestingly, as shown below, used car CPI has shown ZERO fall in used car prices:

  • YTD Manheim shows used car prices down 13% YTD
  • CPI Used cars is 0%
  • Manheim shows used cars now falling at a 50% annualized rate in September
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%

STRATEGY: At face value, Sept FOMC Summary Economic Projections, if realized, is positive equities

Stocks sold off sharply post-Sept FOMC and this reflects the market’s reaction to the hawkish Fed forecasts:

  • Fed made several revisions to their SEP, or Summary Economic Projections
  • they see Fed Funds Dec 2023 at 4.6% (+80b) but only 20bp above FF futures
  • they see PCE inflation at 2.8% by YE 2023 (+20bp)
  • but if these projections are realized, this is actually positive for risk assets, arguably

  • take a step back
  • if inflation by Dec 2023 is 2.8%
  • and Fed funds by Dec 2023 is 4.6%
  • this could be viewed by investors as constructive
  • after all, monetary policy by then is already restrictive
  • and there would be room to cut rates
  • but the key question is timing
  • and as we note above, Fed funds is about to turn restrictive in September 2022
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%

STRATEGY: 2H rally view intact

Given the list of market worries above, the natural question is how is there a positive thesis on equities into 2H2022? Here is our take:

  • our continuing analysis shows leading indicators point to disinflationary/deflation
  • US corporates remain impressively resilient, enduring the pandemic global shutdown with cost discipline
  • and US corporates are weathering the inflation surge impressively as well
  • the US economy has managed to absorb rapid Fed rate hikes so far
  • and US economic relative positioning far stronger in 2022
  • US net beneficiary of higher energy prices, absolute and relative (US exports oil)
  • US is on-shoring assets = future competitive advantage
  • US has labor issues, but this will be solved by either automation or rise in workforce participation
  • investor sentiment is rock bottom and worse than GFC by some metrics
  • fixed income markets show far less inflation in swaps, etc
  • and while many believe “bonds are getting it wrong” including Fed officials
  • the drop in energy and housing and other indicators are supportive of this lower inflation outlook
  • hence, Fed could do far less tightening as the market is doing Fed’s work

Bottom line. We see 2H rally thesis intact.

STRATEGY: 2022 Bear market was 164 days, or 25% duration of prior bull

Our data science team put together the comparative duration of bull markets and bear markets, and the corresponding ratio:

  • since 1942, there have been 14 such cycles
  • median ratio of bear vs bull is 31%, meaning a bear market is roughly 1/3 duration
  • since 1982, this ratio is only 15%
  • in 2022, the preceding bull market was 651 days
  • the current bear market was 164 (using 6/16)
  • or 25% ratio
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%

As seen below, this ratio is solidly within the ranges seen since 1982.

  • many investors think “more time” is needed for this bear market
  • but given the shortness of the preceding bull market 651 days versus 1,309 median
  • the corresponding bear market should also be shorter
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%

BUY THE DIP REGIME: Stocks already saw fundamental capitulation

And we want to revisit the chart below, which looks at the internals of the S&P 500 — the % stocks >20% off their highs, aka % stocks in a bear market.

  • this figure surged to 73% on 6/17
  • this was only exceeded 3 times in the past 30 years
  • each of the 3 prior instances was the market bottom
  • we think this is the 4th instance
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%

BUY THE DIP: forward returns strong

And stocks have the best forward returns when this figure exceeds 54% as shown below:

  • in 3M, 6M and 12M
  • the best decile for returns
  • is when this figure is oversold >54%
  • hence, buy the dip regime is in force
While investors know Fed wants inflation deader than dead, metric is not entirely clear. While not singular, Volcker finally ended war when 3M annualized CPI fell to 2.5%

We publish on a 3-day a week schedule:

Monday
SKIP TUESDAY
Wednesday
SKIP THURSDAY
Friday

 _____________________________

33 Granny Shot Ideas: We performed our quarterly rebalance on 7/12. Full stock list here –> Click here

______________________________

More from the author

Disclosures (show)

Get invaluable analysis of the market and stocks. Cancel at any time. Start Free Trial

Articles Read 2/2

🎁 Unlock 1 extra article by joining our Community!

You are reading the last free article for this month.

Already have an account? Sign In

Want to receive Regular Market Updates to your Inbox?

I am your default error :)