Investors appear to have given up all hope for any soft landing post the Sept FOMC (9/21). Looking at market reactions, post-FOMC:
- Fed Funds futures now pricing 4.75% Fed Funds rate by June 2023
- Inflation breakevens 1-year forward have dropped to 1.97%
- Fed Funds implied June 2023 +38bp
- Inflation 12M forward dropped -32bp
- Implied Fed funds above the Fed’s projection of 4.6% by YE 2023
In other words, one possible way to explain this divergence of the Fed Funds terminal rate up sharply BUT inflation expectations falling is:
- the Fed has lost patience with waiting for inflation to improve
- thus, wants to raise the real cost of money to accelerate the decline in inflation
While the movements in rates raised concerns that a recession is inevitable, this is not necessarily the case. After all, there are a few considerations:
- inflation is set to ease and if labor markets cool, this puts the Fed in a position to pause
- JPMorgan Economists reiterate this, noting a soft landing remains the base case
- this step up in Fed rhetoric can arguably be viewed as “peak Fed hawkishness”
- as long as inflation begins to decline at a faster pace
INFLATION DEATH CROSS: Sticky Core CPI (ex-shelter) is actually cooling to 5.2% annualized from 7.8% in March
When investors cite the risks that inflation will accelerate, many point to the Atlanta Fed’s “sticky” inflation datasets. The “sticky” inflation are those components that see prices adjusting more slowly. But even looking at “sticky core inflation” the news is arguably encouraging:
- sticky core inflation is still at 6.8% annualized
- most economists/strategists only cite the “core sticky” inflation but don’t look at “ex-shelter”
- we believe ex-shelter makes more sense, since shelter follows its own cycle
A far, far different picture emerges looking at “sticky core CPI ex-shelter”:
- ex-shelter, or “sticky core ex-shelter” shows a different picture
- as shown below, 3M annualized “sticky core ex-shelter” is slowing
- and 3M annualized had a “death cross” with 12M YoY
- in other words, the YoY “sticky core ex-shelter” will start to decline
As shown below, the “sticky core ex-shelter” has seen a meaningful decline in the rate of growth:
- in March 2022, annualized 3M growth was 7.8%
- in August 2022, this slowed to 5.2%
- and as noted, there is the “death cross” on the 3M falling below 12M
If you are wondering what is in the “sticky” basket, take a look below.
SF FED: COVID-sensitive inflation still majority of inflation
The San Francisco Fed analysis of CPI shows that COVID-sensitive components remain the largest contributor to Core CPI:
- in other words, as COVID-19 issues abate
- the pressures on core (above) similarly should abate
WAGES: Even latest Atlanta Fed wage-tracker shows meaningful slowing of wage pressures
The Atlanta Fed also maintains a comprehensive survey of wage growth and as shown, there is a pronounced decline:
- economists/strategists tend to solely cite the 3M smoothed figure
- the monthly (spot) wage tracker has fallen for 3 consecutive months
- peak was 7.5% in June 2022
- August was down to 6.3%
- the 3M smoothed has been 6.7% for 3 consecutive months
- but the “real trend” is a decline
This is also seen looking at “weighted” wages.
There will be plenty of economic data in the coming week to further improve the trends in inflation. But the most important will be PCE (personal consumption expenditures). This is also the Fed’s preferred measure of inflation.
TREND INFLATION: NY Fed core trend inflation measure shows decline in August
The NY Fed has developed its own measure of trend inflation, which is designed to more accurately measure trends in inflation better than the traditional core measure:
- the NY Fed underlying inflation gauge
- shows trend inflation has fallen to 4.51% from 4.88% in March
- this is probably the “4.5%” cited by Powell in his post-FOMC comments
- while trend inflation has improved
- Fed would like to see this improve faster
- nevertheless, the monthly drop in UIG is steep
STRATEGY: Retail investors might have capitulated…Investors and even Fed might have reached “peak hawk”
The takeaway is economists/strategists cite “sticky inflation” as the reason for pessimism. But as we highlighted above:
- “sticky core CPI ex-shelter” is falling and now below the 12M YoY
- this is a “death cross” on inflation
- Fed has lost patience with inflation, but if inflation falls at a faster pace
- this allows the Fed to pause (our view)
- sentiment and positioning remain worse than awful
RETAIL: More capitulated than consensus believes
A number of clients are looking for retail investor capitulation before becoming more constructive. There are multiple ways to look at positioning, but the latest Fed flow of funds report suggests retail capitulation might have already taken place:
- take a look at the comments from JPMorgan’s Flows and Liquidity team
- household allocation to equities is the lowest since 2018
- reversing the entire pandemic surge
The JPMorgan report also shows the sharp drop in NYSE margin debt as well.
RETAIL CAPITULATION: AAII 4th worst in history
Another measure of retail capitulation is the latest AAII reading. The survey shows:
- % bulls less % bears -43.2
- 4th worst since 1987
- 3 of the 10 worst readings happened in 2022
Since 1987, top 23 worst readings show pronounced upside
When we start to see the “worst” readings in sentiment, we are surely near retail capitulation. Take a look below:
- 3M, 6M and 12M forward returns are the highest when looking at 23 worst readings
- there is a strong inverse correlation
- worse retail sentiment = better forward returns
- 89% of the outcomes are positive 6M and 12M forward when looking at 23 worst
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