There is no doubt that the single most important driver for global markets this year is inflation. Every single economic release that gives any clue as to whether inflation is coming under control is keenly watched. Any under or over-estimation by market participants leads to an immediate market reaction. My thesis is that inflation can only come under control if the current Fed Funds rate is commensurate with the current year-on-year inflation as measured by Consumer Price Index (CPI YoY). This is backed up by the historical relationship between CPI and the Fed Funds rate.
Historically, the Fed Funds rate has been moving in lockstep with CPI. It tends to be higher than CPI most of the time. Even during the Great Inflation of the 70s, the Fed Funds rate was keeping pace with CPI. It was only during the post-GFC era that the Fed Funds rate has been lagging behind CPI. This is no doubt due to the loose monetary policy implemented by the Fed. This loose monetary policy for over a decade was unsustainable and just waiting for an accident to happen. The accident came in the form of COVID 19 which triggered a global supply-chain shock. The Russia-Ukraine war just added fuel to the fire. This led to a surge in inflation. However, the Fed was slow to react, insisting that the inflation was transitory. And even when it finally admitted that inflation was a problem, the Fed moved slowly. Despite headlines touting the fastest rate hikes in history, the fact remains that there is a big gap between CPI and the Fed Funds rate.
The latest CPI release seems to suggest that inflation is coming down and that got the stock market excited. However, given the unprecedented large gap between CPI and the Fed Funds rate, it is difficult to conclude that inflation is coming under control. As such, the stock market might be getting ahead of itself unless CPI can crash down soon. This leads to a catch-22 situation whereby expectations of inflation coming under control are preventing it from happening. Why? Simply because risk-on sentiments will feed into inflation itself which makes it hard to come down.
What does this mean for markets?
The honest answer is nobody knows for sure. We can certainly look to the past for a guide but history does not repeat exactly and no crisis is the same. Having said that, I think it boils down to whether inflation can be controlled. To get a sense of that, we can look at a few key indicators.
5-Year Breakeven Rate
The 5-year breakeven rate is the market’s expectation of the average annual inflation rate over the next 5 years.
Historically, the 5-year breakeven rate tends to hover around 2% during normal times. 2% is also the so-called neutral rate according to the Fed. The current 5-year breakeven rate is above this neutral rate. It remains to be seen whether it can come back down to 2%. It can remain above 2% for a protracted period just like what happened before the Great Financial Crisis in 2008.
One of the main contributors to inflation is commodity prices because they feed into the raw material cost of many consumer goods as well as for our energy needs. As such, commodity prices are usually good leading indicators for inflation. Commodity prices have to come down before inflation can abate.
DBC is an ETF that tracks a broad basket of commodities. It can be used as a good gauge of commodity prices as a whole. DBC has been on a steady uptrend over the last two years which is one of the major drivers of inflation. It looks like the peak was hit back in June this year (probably due to recession fears) but there seems to be an uptick recently. As I’ve mentioned earlier, risk-on sentiment could feed into commodity prices and this may be what we are seeing. If commodity prices resume an uptrend or stay elevated, this would make it difficult for inflation to come down.
Another major contributor to inflation is labor cost, especially in the services sector. If wages go up, companies would have to pass on some of the increase to customers to maintain their margins.
Wages have been on the uptrend for some time now, even way before inflation became a problem. For inflation to come down, wage growth has to be contained. For that to happen, the current labor shortage situation needs to be resolved. Runaway wage growth was one of the major contributors to the Great Inflation back in the 70s.
Jerome Powell indicated that future rate decisions will be driven by data. I do not know what data he is looking at but based on what I can currently see, it might still be too early to pop the champagne on inflation. Of course, the market is always forward looking so I can be wrong but I do not have the forward-looking data to support the peak inflation theory yet.
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