Lessons from history - Inflation series part 2
I’m writing a series of posts on inflation, and here you can find part 1 and part 3.
The current inflationary global macro regime is unlike any other during the last 40 years. Traders and investors like me are still rewriting our mental map of the market that has served us well over our careers. The main question on many minds is - At what point in this cycle will slowing growth outweigh inflation as a concern for central banks? You have to go back to the 70’s and 80’s to draw parallels of what is happening today. So that’s what I did.
Below is a chart of the Fed funds rate (white), US headline YoY CPI (blue), 5 yr Treasury yields (orange), and US manufacturing ISM (bottom panel). The white vertical lines are where ISM crossed below 50 during periods of slowing growth, marking the transition from economic growth to contraction.
Let’s write a list of observations from the chart above:
The 1970’s saw three waves of inflation, each one peaking higher than the last one. Each wave of inflation required a higher Fed funds rate than the last one to bring it down.
Each wave of inflation and subsequent tightening resulted in a longer and deeper period of economic contraction, based on the ISM
The Fed funds rate spent many quarters, if not several years, above CPI before CPI managed to roll over and trend lower
In each wave, CPI did not peak until 1-6 months after the ISM crossed below 50.
In each wave, the Fed funds rate and 5 yr yields did not peak until after the ISM crossed below 50. During waves 1 and 2, yields traded in a range for at least a year before starting a downtrend. In wave 3, when Volcker was in charge, Fed funds and yields continued to surge higher well after the ISM crossed below 50.
What are some conclusions that we can draw from the 1970s that might apply to today’s environment?
Whatever happens this year or the next, we probably haven’t seen the end to elevated inflation. This could go on for a decade.
The Fed may have to hike rates above CPI to get inflation down. That means hiking to AT LEAST 8%!
It’s likely this cycle will end in an economic contraction (aka recession).
Growth doesn’t become the focus for the Fed and for yields until the ISM crosses below 50. Even then, yields don’t flip from an uptrend to a downtrend immediately- they go sideways for a while (and higher in the case of Volcker).
But wait, didn’t you say last week that growth and inflation are about to slow? Yes, growth is definitely slowing, and inflation is likely taking a breather. However I admit I was wrong about fading the rates move, as it’s way too early to be frontrunning the Fed pivot and the top in yields. For that to happen, we need the ISM below 50. It’s currently at 56.1, so we have a lot more tightening to go!
“Our US inflation LEI ticked up this month (second chart). Our interpretation of the LEI is that although the March CPI print will likely be an interim peak, the future path of inflation will look more like a plateau than a mountaintop and remain uncomfortably above the Fed’s target for at least the rest of 2022.” - Variant Perception
How high can Fed funds go? I’m not sure what’s scarier, the 4th season of Stranger Things or the prospect of Fed funds at 8%. What should give you comfort (but not really) is that QT and surging energy prices will do some of the heavy lifting in slowing down growth. What may end up happening is that Fed funds lands somewhere between the 3% that is priced in today and the 8% that is CPI. Will stocks and crypto like the prospect of more tightening (after just getting used to the idea that the Fed will stop at 2.5-3.0%)? I think not.
That brings us to the European Central Bank…
With a CPI of 8.1%, a policy rate of -0.50%, and an implied policy rate of 1.34% priced in by May 2023, the ECB is laughably behind the curve. 166 bp would have to be added to the front end of the curve just to catch up to the Fed, which arguably has less of an inflation problem than the ECB does right now.
If we take the same framework from the 1st history lesson chart above, this is what the Eurozone would look like today.
ECB deposit rate=white, Headline CPY YoY=blue, 5 yr German bond yield=orange, Composite PMI=eggplant
One can bet on more hikes by shorting Euribor futures or German 2 year bonds. Why does this opportunity exist? First, the ECB promised they would exit its QE program in June before hiking, and that promise removed the option of hiking early and aggressively in response to hotter than expected inflation prints. Second, Europe is dealing with an energy crisis, a war, and widening peripheral government bond spreads, so they have been hesitant to tighten. Third, the ECB governing council (which represents all the countries in the EU) has too many conflicting interests and views, and as a result has always been slower to move than the Fed. Only recently did Lagarde hint at a more hawkish stance after CPI reached a new high in May. Perhaps they are reaching the same panicky moment that the Fed reached back in Feb and March, when Bullard started calling for 3.5% and suddenly consecutive 50 bp hikes became a thing. This Thursday’s ECB meeting will be an interesting one!
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