Scenario analysis of the path of inflation and growth

By now we know that the challenge of forecasting the path of inflation, the economy, and how these all affect the markets is fraught with uncertainty. It requires knowing the path of inflation based on a certain level of employment and economic activity, knowing policy makers’ responses to inflation, growth, and financial market volatility, and knowing the future decisions of geopolitical leaders who control the levers of commodity supply and demand. The best we can do is make a couple fixed assumptions around inflation and use them to write out some scenarios on how everything is going to play out. So here we go!

Before we begin, don’t forget to follow me on Twitter where I comment on news, events, and trades I’m doing.

I’m going to divide the scenarios into four quadrants, with one variable being inflation and the other variable being the Fed’s policy response:

Scenario 1 (transitory inflation):

Growth slows, commodity prices roll over, unemployment turns higher, and inflation starts to sharply trend lower.

Scenario 2 (stick inflation/stagflation):

Growth slows, commodity prices roll over, unemployment turns higher, but inflation stays sticky at 7-9% or above.

Assumption #1 - Growth is slowing, with most PMI indicators for manufacturing and services across the major economies teetering around 50 or plunging below over the last 1-2 months. Employment is still tight, with jobless claims coming in at 250k, but this has been trending higher. Commodity prices from energy to industrial metals are well off their highs, with the exception of natural gas. A mild recession is already priced into the market so the main point of contention for market participants is how deep and how long the recession will last.

Volcker Fed:

The Volcker playbook of overtightening was what ended inflation in the 80’s. To ensure his reputation as an inflation fighter, Powell keeps interest rates high until inflation falls below 5% or wherever Fed funds is at the time. He waits until slack in the labor market is sufficient to reverse wage growth, and for the measures of money supply, bank lending, and consumer credit to be contracting deeply on a YoY basis.

Arthur Burns Fed:

In the 70’s, Arthur Burns presided over high and increasing inflation, which culminated in double digit inflation and interest rates in the early 80’s. Burns managed to hold back two inflation spikes, but his mistake was easing policy too early at the onset of recession. The moment he eased, inflation and commodity prices came roaring back to new highs. He is not completely to blame though - the political environment at the time restricted the Fed’s independence and there was little political appetite for recession.

Now it’s time to assign probabilities to each variable - how likely is it that we get sticky inflation vs transitory inflation, and how likely is it that today’s Fed behaves more like Volcker vs Arthur Burns?

The intention of the Powell and the Fed board members has been made clear repeatedly throughout their speeches - defeating inflation is their top priority. Powell has warned that recession may be a byproduct of their inflation-fighting efforts, which means he is willing to sacrifice the economy for the sake of crushing inflation. Biden is also on the same page with regards to fighting inflation, as inflation is the reason his approval rating of 36% is the lowest in recent presidential history and will likely result in him and the Democrats losing power in the next election.

However the intention of fighting inflation doesn’t equate to success. Failure may result from a miscalculation of how much tightening is required to successfully bring down inflation. Dislocation in the credit and Treasury markets could force the Fed to prematurely halt QT, and even restart QE, like what we saw in March 2020. Therefore I’ll assign a 75% probability that we have a determined and successful Volcker Fed and a 25% probability that events beyond the Fed’s control force them to easy monetary policy prematurely, like the Arthur Burns Fed.

When it comes to inflation - even the best forecasters have been getting it wrong. Sure, the prices of raw materials and energy have been going down over the past two months, and so have PMIs, supply delivery times, new orders, prices paid, property listing prices, and a whole host of economic indicators. Economists have been pointing at those indicators and predicting that inflation would peak for months, to no avail. If you’ve been reading my series on inflation, a contraction in economic activity (signaled by ISM or PMIs falling below 50) is just one precondition for a peak in inflation. The other two preconditions are increasing slack in the labor market (signaled by jobless claims going above 400k) and decreasing money supply. Jobless claims are at 251k today while unemployment is at 3.6% so the labor market is still way too tight to bring inflation down.

As for money supply, the alarming thing is that two out of three measures of money and credit growth still show expansion.

Fed balance sheet - sideways to slightly lower

Consumer credit - deceleration, but still in positive growth territory

Bank credit - positive growth and accelerating

Since two out of the three preconditions for peaking inflation (labor and money supply) are still contributing to inflation, I have to assign the sticky inflation/stagflation scenario a 65% probability and the transitory inflation scenario a 35% probability.

When you plug in the probabilities into the 2 by 2 matrix, this is what you get.

This is what these four scenarios mean for the main asset classes we look at:

Transitory inflation/Arthur Burns Fed - 8.8% probability

Yields peak and start trending lower as the market predicts lower inflation and rate cuts in the near future. An Arthur Burns Fed would loosen policy at the first sign of recession, meaning any recession would be mild. This Fed would surprise the market in pivoting dovish early and aggressively, which would be bullish for risk assets. This would be similar to the Dec 2018 episode, when the Fed tightened in response to increasing inflation but then pivoted after a 20% decline in the SPX. We entered a Goldilocks period after that, and the market experienced a V-shaped recovery.

Transitory inflation/Volcker Fed - 26.2% probability

Yields peak and go sideways as the prospect of lower inflation and rate cuts down the line are balanced by persistent Fed hawkishness and Treasury supply from QT. Even as economic indicators show growth and inflation rolling over, the Fed pushes through 2-3 more hikes to make sure inflation is dead and gone. I think this would result in a longer period of contractionary economic data (6 months or more) and a W-shaped recovery in asset prices. This is the scenario closest to what the market is pricing in right now (stabilization in equity markets, more hikes into year end but cuts in 2023). A risk parity portfolio of long equities and long bonds would do well in this scenario, and it makes sense to start scaling into beaten down risky assets like crypto, high yield credit, etc.

Sticky inflation/Arthur Burns Fed - 16.2% probability

Even as CPI prints remain elevated, the Fed does not turn more hawkish by increasing its estimates of the neutral and terminal rate. The yield curve steepens as the market prices in higher yields 10 years and beyond. Precious metals, commodities, and crypto start a new bull trend as it becomes clear the Fed’s appetite to fight inflation is limited. Equities trade sideways in a choppy manner, caught between the cross currents of higher yields (which puts pressure on valuations) and nominal earnings that are trending higher despite an economy that is weakening in real terms.

Sticky inflation/Volcker Fed - 48.8%

As CPI remains elevated, the Fed gets more aggressive with its front-loaded hikes. The September dots show estimates of the terminal rate at 4.5%, and the December dots show 5.5%. The inversion at the front end of the curve becomes more extreme, with hikes extending out to H1 2023 and then steep cuts thereafter. The aggressive Fed tightening results in unemployment reaching 6% by 2023 and ISM readings in the 30s and low 40s for Q4 2022-Q2 2023. As earnings and economic data deteriorate, equities sell off harder and SPX falls down to the 3000-3400 range, a 30-40% drawdown from the all-time high. Credit spreads widen dramatically, and bankruptcies increase as zombie companies fail to roll over their debt. A few emerging market countries fall into a debt crisis, while dysfunction in the Treasury and credit markets could trigger heightened volatility. By the time the Fed is done, people will no longer be complaining about inflation and will instead be focusing on unemployment and financial hardship.

Current positions

My favorite trades to bet on the sticky inflation/Volcker Fed scenario are to be short risky assets like equities, which at current levels offer great risk reward for shorts. My sense is that 4000-4100 in SPX should cap the upside on what I believe is a bear market equity rally, while my near term downside target is in the 3400-3600 range. With VIX back below 25, buying 2-4 month puts is also not a bad way to play this.

The other trade to bet on a more hawkish Fed is to be short the eurodollar Mar 2023 contract. I had to stop out of this short last Friday, but the market continued to squeeze higher and gave me the opportunity to re-sell at better levels. It’s trading at 96.42 at time of this writing, and if the Fed ends up hiking to 5% by the end of the year, that contract should trade down below 95.00

Below is the shape of the eurodollar interest rate curve, with the peak being Dec 2022. I expect that peak to get pulled up and to the right as the Fed continues down its hawkish path. This would cause Mar 2023 to shift from pricing in a cut after December to pricing in hikes.

I’m also short eur/usd FX, as the Fed and ECB are embarking on different policy paths due to differing economic and political constraints. Both the US and Eurozone are struggling with 8-9% inflation. The Fed is on an inflation-fighting campaign, backed by Biden and Congress, while US growth is not in contraction (yet). The ECB, on the other hand, is much farther along in sliding into recession, as their unfolding energy crisis is causing demand destruction that is impacting manufacturing and industry. The ECB just hiked to bring its policy rate to 0%, and will likely continue making gradual and insufficient steps to tighten. My sense is that the gap between inflation and the policy rate, as well as the gap between inflation and growth, will continue to widen over coming months, resulting in their currency getting devalued at a much faster rate than the US dollar. The euro is also losing a key pillar of support - Germany’s current account surplus that creates natural demand for Germany’s exports and the euro currency. Germany’s current account surplus is dwindling quickly to a deficit for the first time since 2022, turning a tailwind for the euro into a headwind.

I’ll be running these trades into the FOMC tonight, as I think Powell will push back on current market pricing in the rates market (which has priced in fewer rate hikes since their last meeting on Jun 14) by sounding extremely hawkish.

Keep in mind that I don’t just hold these positions through thick and thin - I try to pick my spots and capture large chunks of the move, and either take profit or exit through trailing stops. This blog is also not meant to be a signaling service, so don’t copy my trades! None of this is meant to be financial advice.

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