Inflation & Interest Rates: share your data sources, models, and assumptions

[wageslave23]

Do you think the interest rate hikes should have had an effect on the hard data already?  I was thinking that the interest rate hike effects would have about a 6 month lag. I have no basis for this, just stating that it's not surprising to me and I don't read anything into the "numbers" not changing yet. If by the end of this year inflation has not started decreasing then I would be willing to say that the interest rate hikes in the beginning of the year were not adequate.

Also, if I was a business, I would not buy something with a 4% loan because inflation has been 9% over the previous 12 months. I would look at what I thought inflation would be over the next 12 months or even 3 to 4 4 years.  I would think that either inflation is going to decrease on its own by increasing capacity and spending down stimulus stockpiles, or the federal reserve will continue to raise rates until a recession lowers inflation.  Either way, I don't see a scenario where inflation is still high in 3 yrs from now. The fed won't let it.

[ChpBstrd]

I agree that the Fed will win eventually, and that markets use their own forward estimates of interest rates to set asset prices. Current asset prices are arguably in line with the market's estimates of 5-year or 10-year interest rates. I.e. there is a positive risk premium between the earnings yield and the forward estimates of treasury rates.

I also agree that it's problematic to use prior months' data to extrapolate trends into future months. Market metrics wouldn't look like zig zags if that were a reliable method. By the time historical data are released, the market has generally adjusted its pricing, so there is no performance advantage to being an informed investor versus the famous dead investors whose Fidelity portfolios performed best. If we decide to stay out of the market until historical risk metrics improve, then by that time the risk premiums we are paid will decrease.

So neither of these are the question. The question is whether market expectations are possible to occur, or if the market is expecting something irrational to happen. Today I'm looking at the history of the Federal Funds Rate versus CPI. The questions are: Has an increase in the FFR to a level below CPI ever been followed by a decline in CPI to below the FFR? If yes, then what happened to stocks and bonds during that time?

In the chart below, there are no examples of the specific scenario we face today - only a handful of times when CPI>FFR.

In 1955-1958 CPI rose from deflation to 3.75% despite a rate hiking campaign that took the FFR from 0.25% to 3.5%. The interesting thing here is that rates started being cut in November '57 after the start of a recession but inflation didn't peak until April '58. Was it the recession or was it the delayed reaction to interest rate hikes that extinguished inflation? Inflation fell even as the FFR fell by about 200 basis points. Still, the FFR stayed above CPI for the duration of the rate hikes, and the CPI only exceeded the FFR on the right side of the peak, as the FFR fell faster than the CPI. The recession caused a -10.78% total return on the S&P500 in 1957, to be followed by a 43.4% rally in 1958.

In 1973-74, the FFR rose to a peak of 13.3% in response to rising inflation. As in the late 50's, the FFR stayed above CPI for the entire rate hiking campaign, and then the CPI was briefly above the FFR, after the FFR was cut in response to recession. Again, CPI was only above FFR on the right side of the peak, when FFR was falling faster than CPI. The S&P500 had a total return of -14.66% in 1973 and -26.47% in 1974.

A different pattern emerged in the 21st century. Post 9/11 rate cuts caused the FFR to fall below CPI in 2002 and stay there until 2005. CPI continued on a rising trend while it was above the FFR, as the Taylor Rule would predict. Once the FFR had finally climbed above the CPI, CPI fell as the Taylor Rule would predict. Then from January 2008 to February 2009, we again saw the familiar pattern of the FFR falling faster than inflation amid a recession, like we saw in the 50s and 70s. An optimist might say that OK returns occurred between 2005 and mid-2007, Total returns were:

2009    26.46
2008    -37.00
2007    5.49
2006    15.79
2005    4.91
2004    10.88
2003    28.68
2002    -22.10

The post-GFC relationship between the CPI and FFR looked like nothing in history. With the FFR near zero, CPI maintained itself in a narrow band at the low end of its historical range. After a brief dip into deflationary territory in 2015 that was not declared a recession, the FFR started going up from near zero to near 2.5%. The CPI continued increasing until the FFR exceeded inflation, as the Taylor rule would predict. The crossover occurred in November 2018, and a 20% stock correction started that December.

Overall, we should all be able to agree on the following:
The only time in history when inflation fell while (a) the FFR was below inflation and (b) a recession was not occurring, was 2011-2015. This period was the only sustained violation of the Taylor Rule that has ever occurred.

So if stocks/bonds are fairly priced according to the bond market's current predictions of imminent recession and rate hikes ending in November or December, then stocks could rise if the recession is indicated sooner or fall if the recession takes even a couple of months longer than expected to occur. The Fed will keep handing out rate hikes until the recession happens, so quotes like the following from the CEO of American Express seem bearish:

"We're acquiring spending and we see future travel bookings [strong] so I don't see it [a recession] in my numbers at all," Squeri told Yahoo Finance.

"It's really hard for me to get my head around that in quarter three or quarter four we're going to have a big slowdown," Squeri said. "But if we learned anything during the pandemic, you kind of go day-to-day, month-to-month, and so as I sit here today, I do not see [a recession]."

Indeed there were no signs of a recession in Amex's results that hit the wires on Friday. Sales rose 31% from a year ago and spending on cards by Amex members surged by the same amount.

https://www.msn.com/en-us/money/topstocks/dont-see-it-in-my-numbers-american-express-ceo-doubts-recession-fears/ar-AAZRzDh

New quote from former Fed president Jeffrey Lacker:

“To let your foot up off the brake before inflation has come down” is just a “recipe for another recession down the road,” Lacker said, in an interview on Bloomberg Television.

The central bank “might as well get it done” and get rates up fast, he said.

https://www.marketwatch.com/story/fed-cant-stop-hiking-interest-rates-even-if-there-is-a-recession-former-top-central-banker-says-11658503782?siteid=yhoof2

[EscapeVelocity2020]

The July 27th 75 bp rate hike is virtually guaranteed, since the Fed says there will be no more surprises.  This will put the Fed in a more reactionary position going forward and the market is forecasting rate hikes to moderate…. Not even sure I agree with the underlying assumption that a recession will result in inflation subsiding sufficiently…. But equities are up this past week and treasury yields took a nosedive on Friday, so I don’t think anyone knows where this is headed. 

[ChpBstrd]

The Taylor Rule and the unprecedented gap between inflation and the Federal Funds Rate have me questioning the market's consensus that a recession in late 2022 will knock the CPI/PPI down to the 2% range by January.

Will the July CPI number show a reduction in the rate of inflation because commodities are about 12.6% cheaper (so far) than they were last month? Or, is policy still stimulative, and is the difference between PPI and CPI I noted earlier a sign that delayed price hikes are about to flow down to the retail level and be measured by CPI / core CPI?

To determine whether policy is stimulative, I thought about the microeconomic level and examined decisions consumers and producers have to make right now. If it's getting close to time to buy a car, washing machine, pesticides for your farm, a new roof, or industrial equipment, you have to decide whether it makes sense to take on debt to buy the thing now, or if it makes more sense to save up your money for a while and buy the thing later.

Let's say I have my eye on a 2022 Toyota Corolla Hybrid (OK, so most new vehicles cost twice as much, but humor me here). This vehicle has a base MSRP of $24,050 today. If I think inflation will be 7%, then this vehicle will cost me $1,684 more to buy if I wait until next year. But if I borrow to buy the vehicle today at Toyota's advertised 1.9% rate, I'll pay maybe $250-$400 in interest in the first year, depending on the size of my down payment. Buying the car now as opposed to later even makes sense if I need to sell treasuries out of my stache to buy it, because that opportunity cost is only ~3%, or less than half of expected inflation. Going into debt right now is cheaper than the cost of inflation. Plus, the depreciation of my 2022 model will be lower because the person I sell my Corolla to will be measuring its remaining utility against a brand new model with a much higher price in the future.

The calculation is the same for the trucking company thinking about buying more trailers, the manufacturer thinking about production equipment, the farmer thinking about a new implement, the family thinking about building a home, and the student thinking about a new macbook. Interest rates are lower than inflation, so they are all incentivized to pull their spending forward and buy things before the price goes up. The same is probably true for the users of commodities. If you are an airline or trucking firm, maybe you lock in the cost of fuel. If your company bakes wheat bread or makes aluminum components, maybe you buy futures on those commodities. Again, all these incentives are to pull demand to the present for things that will be consumed later.

Maybe this explains why consumer spending is so high even though consumer sentiment is terrible. This isn't even a wage-price spiral, it's a rational reaction to borrowing costs that are much lower than the rate of inflation. Consumers and producers are not happy about this situation; they have to spend aggressively in order to avoid being damaged in the future. This is why the PCE for durable goods and the Manufacturer's New Orders for durable goods are both accellerating, and possibly causing shortages:




But if demand stays strong through the next few months due to this scramble to buy things ahead of inflation, it's entirely possible the recession gets postponed. Somebody has to produce, transport, warehouse, and retail all those things we're buying, so employment could hold up fine. If the recession gets postponed, inflation will stay high and rate hikes will continue into early or mid-2023. If that occurs, we're looking at rates around 7% next summer instead of the 3.5% predicted by the Fed Funds futures market:

https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html 

This matters because a FFR of let's say 7% plus a risk premium of let's say 1.5% would require stocks to have a earnings yield of 8.5%, or a forward PE around 12!

Perhaps the market is assuming a brief recession and inflation going away this fall because we've never lived in such a world where people are pulling their spending forward and the S&P500 has a PE ratio in the low teens. Yet this was not an uncommon situation, historically speaking.

[maizefolk]

Let's say I have my eye on a 2022 Toyota Corolla Hybrid (OK, so most new vehicles cost twice as much, but humor me here). This vehicle has a base MSRP of $24,050 today. If I think inflation will be 7%, then this vehicle will cost me $1,684 more to buy if I wait until next year. But if I borrow to buy the vehicle today at Toyota's advertised 1.9% rate, I'll pay maybe $250-$400 in interest in the first year, depending on the size of my down payment. Buying the car now as opposed to later even makes sense if I need to sell treasuries out of my stache to buy it, because that opportunity cost is only ~3%, or less than half of expected inflation. Going into debt right now is cheaper than the cost of inflation. Plus, the depreciation of my 2022 model will be lower because the person I sell my Corolla to will be measuring its remaining utility against a brand new model with a much higher price in the future.

The calculation is the same for the trucking company thinking about buying more trailers, the manufacturer thinking about production equipment, the farmer thinking about a new implement, the family thinking about building a home, and the student thinking about a new macbook. Interest rates are lower than inflation, so they are all incentivized to pull their spending forward and buy things before the price goes up. The same is probably true for the users of commodities. If you are an airline or trucking firm, maybe you lock in the cost of fuel. If your company bakes wheat bread or makes aluminum components, maybe you buy futures on those commodities. Again, all these incentives are to pull demand to the present for things that will be consumed later.

Maybe this explains why consumer spending is so high even though consumer sentiment is terrible. This isn't even a wage-price spiral, it's a rational reaction to borrowing costs that are much lower than the rate of inflation. Consumers and producers are not happy about this situation; they have to spend aggressively in order to avoid being damaged in the future.

Yup. And what you are describing is exactly the sort of (perfectly rational given individual people's incentives) acceleration in the velocity of money that can continue to drive up inflation, even in the absence of any changes to the money supply.

[wageslave23]

In theory, should we want high interest rates during the accumulation phase and early part of FIRE and then falling rates in our later years of life?  That way the saving and investiing is rewarded with a higher return for the majority of our lives and then capitalize on high equity valuations by selling off shares while interest rates fall towards the end of life.

[Bartlebooth]

In theory, should we want high interest rates during the accumulation phase and early part of FIRE and then falling rates in our later years of life?  That way the saving and investiing is rewarded with a higher return for the majority of our lives and then capitalize on high equity valuations by selling off shares while interest rates fall towards the end of life.

Do real (inflation-adjusted) returns on saving and investing tend to be higher during periods of high inflation?

Personally, I doubt it. I would expect that the biggest benefit to experiencing a period of high inflation at some point in your life would be the erosion of any large debts that you have.

[EscapeVelocity2020]

In theory, should we want high interest rates during the accumulation phase and early part of FIRE and then falling rates in our later years of life?  That way the saving and investiing is rewarded with a higher return for the majority of our lives and then capitalize on high equity valuations by selling off shares while interest rates fall towards the end of life.

Yup, Baby Boomer generation did pretty well with the high but falling inflation scenario.  Too bad it won’t be repeated without a severe economic dislocation, cranking the Federal Funds Rate to double digits would blow up all the entrenched investment banks, too big to fail banks, and even the US government balance sheet…

[EscapeVelocity2020]

Id say that the Fed blew it on their messaging.  The markets took ‘no forward guidance’ to mean that they won’t or can’t raise rates much more.  The 10 year Treasury rate continued to plummet to 2.6% which basically says the 3% yield was a heck of a deal.

So now we hope and pray that inflation subsides without a recession being necessary…. Risk assets have rallied on the idea that policy will remain mostly accommodative.  My prediction is for even more severe stagflation for longer, until the Fed takes the punch bowl away once and for all…. And this hangover is gonna suck!

[PDXTabs]

In theory, should we want high interest rates during the accumulation phase and early part of FIRE and then falling rates in our later years of life?  That way the saving and investiing is rewarded with a higher return for the majority of our lives and then capitalize on high equity valuations by selling off shares while interest rates fall towards the end of life.

Do real (inflation-adjusted) returns on saving and investing tend to be higher during periods of high inflation?

Personally, I doubt it. I would expect that the biggest benefit to experiencing a period of high inflation at some point in your life would be the erosion of any large debts that you have.

But wageslave23 wrote "high interest rates" not "high inflation." On one hand a high rate environment might give you positive real yields on government debt followed by falling rates (where bond prices move up). On the other hand low rate low inflation environments are phenomenal at producing corporate profits and equities increases (this is what we saw from 2008-2021).

[ChpBstrd]

Id say that the Fed blew it on their messaging.  The markets took ‘no forward guidance’ to mean that they won’t or can’t raise rates much more.  The 10 year Treasury rate continued to plummet to 2.6% which basically says the 3% yield was a heck of a deal.

So now we hope and pray that inflation subsides without a recession being necessary…. Risk assets have rallied on the idea that policy will remain mostly accommodative.  My prediction is for even more severe stagflation for longer, until the Fed takes the punch bowl away once and for all…. And this hangover is gonna suck!

I agree that the market took a different message than what the Fed was saying. For how many months have Powell and the other members of the FOMC talked about their goal of getting to a "neutral" interest rate that neither stimulates nor inhibits inflation? That rate was quoted as around 2.5%, the economy's estimated capacity for sustained growth. Here we are now with a 2.5% rate, just in time for a two-month gap between Fed meetings which can be used to ascertain inflation's natural tendency now that the interest rate is no longer a factor.

When the FOMC meets again in September, what kind of July and August data will they be looking at? The Taylor Rule will be tested again!

I'm starting to coalesce around a view that rising demand for durable goods means consumers and businesses are racing to buy things now before the prices go up, and negative real rates are encouraging people to lock in prices on everything from cars to business inventories to commodities. They can borrow to buy next year's supplies now at a lower cost than if they waited a year and paid cash. I think all this pulling forward of demand will keep employment afloat and stave off a recession until 2023 at the earliest. Such a timeframe would be typical after yield curve inversion:

https://www.statista.com/statistics/1087216/time-gap-between-yield-curve-inversion-and-recession/

That's really bad, because it means we're looking at 0.75% hikes in September, November, and December, which would put the FFR at the end of this year around 4.75% rather than the market expectation of 3.5%. That's the difference between a fair PE ratio for the S&P500 being 15 instead of 20! The July decision to only hike 0.75% was a cop-out in the face of 9.1% CPI. I think high inflation will continue as the FOMC climbs a credibility wall this fall and winter, and might hike rates in February too. When this gets priced in, the 2nd half of 2022 will look a lot like the first, and a buying opportunity will have arrived.

In the meantime, I don't rule out another massive rally in early August on the rationale that falling GDP means the recession is already here and "the bottom is in". What such investors are not paying attention to is the leading indicator through all this: Commodities are rising again off their 7/14 lows. The S&P GSCI index is up over 6% off its lows. The CRB index is up over 7%. The LME is up over 8%. Oil is up $5 since 7/14, and may be heading back to $100. If the recession is here and demand is slowing, how are commodities rising? You can't have both, right? In just the past two weeks, it appears commodities went into no-recession mode at the same time stocks and bonds went into recession mode.

[blue_green_sparks]

We have been retired for over 3 years now. I track our expenses month to month and keep a running average to see our cost-of-living trends. We live in a LCOL area and so far, meh.  We only drive maybe 20 miles a week. We have been growing more food in our garden (for enjoyment, mostly) and haven't had to make any major repairs or purchases.....I think that's when inflation can hurt us most.

Currently our fixed income generates $2500/month so not selling any stock just yet. I hate selling stock at a discount, LOL.

[Mr. Green]

So much for a recession. July jobs report just came out. Over 500,000 jobs added and unemployment rate has dropped to 3.5%, tying the record low. I'm sure the odds on a bigger rate hike in September just jumped, as this likely means inflation will continue running hotter than the Fed wants.

[Mr. Green]

Last night Krysten Sinema came onboard the $700 million climate package and this morning it was announced that mass student loan forgiveness may be coming as soon as the next week. I'm happy to see people absolved of student loans that have ridiculous, mafia-like interest rates (considering student loan debt is basically bombproof on one's credit record). Both of these items will put upward pressure on inflation. It will be interesting to see if mass student loan forgiveness has a noticeable impact on the housing market as tons of people may suddenly find themselves able to get a mortgage.

[wageslave23]

Last night Krysten Sinema came onboard the $700 million climate package and this morning it was announced that mass student loan forgiveness may be coming as soon as the next week. I'm happy to see people absolved of student loans that have ridiculous, mafia-like interest rates (considering student loan debt is basically bombproof on one's credit record). Both of these items will put upward pressure on inflation. It will be interesting to see if mass student loan forgiveness has a noticeable impact on the housing market as tons of people may suddenly find themselves able to get a mortgage.

Yeah if Biden was smart, he'd keep student loan forgiveness in his back pocket for when the economy needs a little boost next year. No need to keep adding gasoline to the fire.  Same with the "inflation" bill but I'm guessing with that they are worried about losing the majority next year

[ChpBstrd]

So much for a recession. July jobs report just came out. Over 500,000 jobs added and unemployment rate has dropped to 3.5%, tying the record low. I'm sure the odds on a bigger rate hike in September just jumped, as this likely means inflation will continue running hotter than the Fed wants.

Yes, and also consistent with my no-recession-in-‘22 prediction earlier. Expect 0.75% rate hikes at every meeting for the rest of this year as consumption is pulled forward, wage pressures and unemployment stays low, and CPI catching up with PPI. Investments are still too expensive.

Edit: Here’s more evidence people are pulling ahead their purchases - consumers added $40B in debt in June. Consumer balance sheets entered this episode of high interest rates healthy, so the loading up on debt could go on for a while. When consumers can spend no more, the layoffs start, and the consumers cut spending to pay down debt.

https://www.cnn.com/2022/08/05/economy/june-consumer-credit-report-debt-increase/index.html

[wageslave23]

This is what I would like to see:
https://www.marketwatch.com/story/roaring-labor-market-puts-boomflation-back-on-the-map-for-investors-11659789508

Play hardball and make sure we turn the corner on inflation but then the drop from 8% inflation down to 2% could be over the course of two years. As supply chains work themselves out, people spend down their surplus stimulus and have to re enter the workforce and slow discretionary spending. Once inflation is heading in the right direction, I see no benefit to slamming the economy to a halt in order to get it down to 2% within 6 months as opposed to working with the organic forces to bring it down over the course of time (two to three years).

[Edubb20]

Last night Krysten Sinema came onboard the $700 million climate package and this morning it was announced that mass student loan forgiveness may be coming as soon as the next week. I'm happy to see people absolved of student loans that have ridiculous, mafia-like interest rates (considering student loan debt is basically bombproof on one's credit record). Both of these items will put upward pressure on inflation. It will be interesting to see if mass student loan forgiveness has a noticeable impact on the housing market as tons of people may suddenly find themselves able to get a mortgage.

The problem is the lenders are still getting paid. No reason for them to stop the bad behavior. I'm all for eliminating the debt on the student side, but doing it without fixing the predatory lending/tuition hike cycle doesn't fix much in the long run. Instead of them picking the bones of the individual, they are going to get faux gras'd by the government.

[ChpBstrd]

My crystal ball is flickering and occasionally sparks, but here's what it's currently showing. I'm sure this won't be a humbling experience in a few months ;)

AUGUST
August CPI to be released 8/10: >8.5%
A recent Bloomberg survey of economists pinned the average consensus at about 8.7%
Economic data continues to be strong, but profit margins become compressed as retailers catch up with the PPI.

SEPTEMBER
CPI: >8%
0.75% rate hike to 3.25% upper bound
Markets correct, taking back gains from the July/Aug bear rally
More strong economic data arrives, unemployment remains very low

OCTOBER:
CPI: >8%

NOVEMBER:
CPI: >8%
0.75% rate hike to 4% UB

DECEMBER:
CPI: >8%
0.75% rate hike to 4.75% UB

JANUARY/FEBRUARY 2023:
CPI: >7%
0.75% rate hike to 5.5% UB
Christmas sales will be a disappointment due to consumers pulling ahead purchases in 2022 and a low savings rate.
Post-xmas layoffs start being announced throughout supply chains.

MARCH 2023:
CPI: >7%
0.5% rate hike to 6% UB
S&P500 ttm PE ratio: 17
market bottom, amid concerns of a housing correction and financial industry stresses

APRIL 2023:
Recession starts
Nationwide house prices fall YoY, amid 7-8% mortgages
CPI: >6%

MAY 2023:
0.25% rate hike to 6.25% UB
S&P500 ttm PE ratio: 16-17

All these predictions are off-the-charts compared to the CME's FedWatch tool, implying massive changes in the value of existing futures contracts if my crystal ball is correct. For example, the current futures pricing structure implies a 0.1% chance of rates being higher than 4.5% in June 2023. Are the odds really that low?

https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

This reveals an execution problem. I'm not even a novice futures trader, because I don't like the idea of owning a derivative without a known, fixed downside, so I'm learning about Federal Funds Options. If my crystal ball is correct, these instruments could offer excellent hedging or speculative potential.

https://www.cmegroup.com/markets/interest-rates/stirs/30-day-federal-fund.quotes.options.html#optionProductId=306&expiration=306-H3

Less directly, I am still attracted to the idea of buying puts on TLT or ZROZ.

Another thing this exercise reveals is the extent to which the stock and bond markets are relying on a form a market timing - specifically timing the onset of a shallow recession to within a range of a couple of months. If the recession doesn't start by the end of this year, and if the rate hikes don't stop by the end of this year, then not only will markets need to price in a terminal rate a percent or two higher than previously thought, but they'll also have to re-evaluate today's consensus that inflation can be controlled by an FFR lower than the rate of inflation. If the realization sets in that monetary policy is stimulative or inflationary anytime FFR<CPI, then a real crash could occur. Time is running out on the narrative that a short, shallow recession starting in late 2022 will save us from further rate hikes.

The missing variable in all of this is the same missing variable I've pointed out all along: quantitative tightening. Perhaps J. Powell is dismissing the effect of QT as a minor thing in public, but is privately aware that sucking hundreds of billions of dollars out of the economy is having a bigger effect than a mere quarter-point rate hike as he estimated earlier. Perhaps this is why the Fed is not treating a 9.1% and rising CPI as a true emergency, by raising rates sooner and faster. If the effect of QT is more like a quarter-point rate hike every month, rather than all together, then it's more like we are raising rates 1% per FOMC meeting as opposed to 0.75%. By that rationale, a recession could come sooner rather than later.

I disagree, and see the QT as too little too late. I think a falling Personal Savings Rate, rapidly rising Inventories, and Initial Claims at levels seen in 2015-2019 suggest both consumers and producers will be accelerating consumption for the next several months. Eventually, consumers will exhaust their reserves, retailers will get nervous about their sky-high inventories, unemployment will increase, demand will fall to meet supply, and clearance sales will reduce inflation.





But I fear the markets are priced for this recession to play out within the next four months, instead of the next 12-18 months. As we can see from history, previous steep rate-hiking campaigns took a year or more to produce a recession, including Oct '67 - Aug '69 (~5.25% total hikes), Feb '72 - Sept '73 (~7.5% total hikes), April '77 - Dec '79 (~9% total hikes), and May '04 to July '06 (~4.25% total hikes). In comparison with these episodes, we are currently five months and 2.25% of the way into this rate hiking cycle, and this is the first time we've allowed the CPI to get ahead of the FFR. I'm not sure if policy is stimulative, but I think there's a case to be made that it's not restrictive yet.



I need counterarguments. How could the markets be right about an inflation-stopping recession starting later this year?

[EscapeVelocity2020]

I don't have any bullet point by bullet point refutation of your predictions, but the good news would be that markets will get that reality check sooner rather than later if your predictions play out.  Inflation hasn't been this high in our modern computer age (the theory being that tech is inherently deflationary, boosts productivity, etc.), so I can see why markets expect inflation to fall solely based on supply chains getting fixed, which is assumed to happen with time regardless of Fed intervention.

Quantitative tightening is a wild card in all of this.  The Fed could follow the expected rate path and fiddle more with messaging around QT to bring about a mild recession, but this tool is unproven and unpredictable.  The markets start to crash when QT bites, but QE and QT are powerful tools that have little constraint or transparency...  There is also the strength of the USD as a wild card.  It would help our economy if USD weakened, but markets might get less global investment inflow if that 'free lunch' is taken away.

Again, I'm glad I'm not a trader.  The market seems to be whistling in the graveyard (crypto up, meme stonks up, VIX is down, 10-year is jumping all around), so a sudden shakeup is overdue if we are to dry up liquidity and tamp down inflation.  When will this happen?  Is the Fed even concerned?  Nobody seems to know nuthin'.  Is this a bear market rally?  Is this the start of a new bull?  I've seen articles arguing both (although the bear arguments seem more convincing).

Edit to add - Just came across this YouTube video that does a much more polished job of what I was trying to say earlier, as well as pointing out that the CPI read tomorrow should be interpreted carefully.  Both substitution (choosing a lower priced similar good) and not accounting for things like shrinkflation gives the CPI a downward bias, even though 'real people' experience higher inflation.  Also pointed out that QT should be ramping up further soon, but currently the Fed balance sheet is not showing MBS net sales (there is a 3 month window / time delay, so balance sheet won't reflect the sales until November).  Anyway, the 30B in Treasury Bond sales should be going up to 60B / month and 17.5B in MBS goes to 35B...  And these sales are expected to go on for the next 2.5 years...

[Mr. Green]

DECEMBER:
CPI: >8%
0.75% rate hike to 4.75% UB

JANUARY/FEBRUARY 2023:
CPI: >7%
0.75% rate hike to 5% UB

@ChpBstrd I just wanted to point out that there's a math error in your Jan/Feb 2023 spot. The jump to 5 from 4.75 is only a quarter point. Assuming you intended it to be three quarters, all rate after that are actually half a point higher!

[ChpBstrd]

DECEMBER:
CPI: >8%
0.75% rate hike to 4.75% UB

JANUARY/FEBRUARY 2023:
CPI: >7%
0.75% rate hike to 5% UB

@ChpBstrd I just wanted to point out that there's a math error in your Jan/Feb 2023 spot. The jump to 5 from 4.75 is only a quarter point. Assuming you intended it to be three quarters, all rate after that are actually half a point higher!

Fixed. Thanks! The trajectory looked bad even before I fixed the error. Now it looks worse.

When we think about stock valuation under different interest rate regimes, we need to think in terms of the risk-free rate plus a risk premium. The risk-free rate is usually thought of as the 10-year treasury yield, which itself usually has a premium over short-term interest rates like the overnight Federal Funds Rate, because investors usually demand compensation for the duration risk they are accepting with longer-term instruments. But for simplicity, let's just say the risk free rate is the FFR and the risk premium is a mere 2%.

No Risk    Risk Premium          Stock Earnings Yield          Stock P/E
0%          2%                         2%                                    50
1%          2%                         3%                                    33
2%          2%                         4%                                    25
3%          2%                         5%                                    20
4%          2%                         6%                                    17
5%          2%                         7%                                    14.3
6%          2%                         8%                                    12.5
7%          2%                         9%                                    11.1

This CAPM model demonstrates why interest rates are the news and everything else is the noise.

However, there have obviously been times where stock PE ratios have been much higher than those prescribed above. 5-7% is not a historically unusual risk-free rate, but environments with PE ratios below 14 are getting to be rare. To some extent, investors lower their required risk premium in high-rates / high-inflation environments because of stocks' presumed ability to raise prices and therefore mitigate inflation. When inflation takes a bite out of one's bond coupon payment, there is no hope of ever recovering that purchasing power because the terms of the bond are permanently fixed. But stocks offer a different returns function.

As inflation rises, investors seem to place a higher weight on the nominal growth potential of earnings, and reduce their risk premium accordingly. This is because over a long timespan a rising series of cash flows can be worth more than a flat series of cash flows, even when heavily discounted. For retirees and pension funds, there is also the simple logic of what to do when only a rising series of payments can prevent them from running out of money; you invest in the rising series of payments. In 1980, for example, when investors could have earned 13-15% on 10 year treasuries, many were buying stocks at a PE of 10, or an earnings yield of 10%, paying more for the cashflows from the more volatile instrument! So maybe the risk premium is a curve and looks more like:

No Risk    Risk Premium          Stock Earnings Yield          Stock P/E
0%          2.5%                      2.5%                                 40
1%          2%                         3%                                    33
2%          2%                         4%                                    25
3%          2%                         5%                                    20
4%          1.75%                    5.75%                               17.4
5%          1.5%                      6.5%                                 15.4
6%          1%                         7%                                    14.3
7%          0.5%                      7.5%                                 13.3

...with the risk premium going negative when investors' forecasts for future inflation reach a certain level, as occurred in my 1980 example. From what I've read, people in that era expected high inflation forever.

If I'm predicting 6%+ risk-free rates next year, the logical plan is to stay out of the market for the drop and then buy after the drop. But then one needs to establish a "buy" level. This is tricky because earnings-based valuation metrics stop working during and after recessions, because the previous 12 months earnings are temporarily impaired and forward estimates are all over the place. PE ratios tend to go up during recessions, not down. If I simply say "I'll buy when the PE is 15" then that day might never come. An investor who was right about the 2000-2003 bear market would have never gotten back in by that metric. If I say "a PE of 15 based on the TTM earnings looking back from August 2022" then that's a S&P500 level of about 2950, or about 28% down from here.

[maizefolk]

As inflation rises, investors seem to place a higher weight on the nominal growth potential of earnings, and reduce their risk premium accordingly. This is because over a long timespan a rising series of cash flows can be worth more than a flat series of cash flows, even when heavily discounted. For retirees and pension funds, there is also the simple logic of what to do when only a rising series of payments can prevent them from running out of money; you invest in the rising series of payments. In 1980, for example, when investors could have earned 13-15% on 10 year treasuries, many were buying stocks at a PE of 10, or an earnings yield of 10%, paying more for the cashflows from the more volatile instrument! So maybe the risk premium is a curve and looks more like:

No Risk    Risk Premium          Stock Earnings Yield          Stock P/E
0%          2.5%                      2.5%                                 40
1%          2%                         3%                                    33
2%          2%                         4%                                    25
3%          2%                         5%                                    20
4%          1.75%                    5.75%                               17.4
5%          1.5%                      6.5%                                 15.4
6%          1%                         7%                                    14.3
7%          0.5%                      7.5%                                 13.3

...with the risk premium going negative when investors' forecasts for future inflation reach a certain level, as occurred in my 1980 example. From what I've read, people in that era expected high inflation forever.

Instead of assuming different risk premiums at different nominal interest rates or in different inflation environments, perhaps the better way to look at this would be to look at "real" risk free rates rather than nominal ones?

The returns of stocks are much more volatile than, say, TIPS, but in principle the 30 year return of both in real terms should be independent of inflation, while a regular 30 year bond can essentially go to zero in a high inflation environment.

[ChpBstrd]

As inflation rises, investors seem to place a higher weight on the nominal growth potential of earnings, and reduce their risk premium accordingly. This is because over a long timespan a rising series of cash flows can be worth more than a flat series of cash flows, even when heavily discounted. For retirees and pension funds, there is also the simple logic of what to do when only a rising series of payments can prevent them from running out of money; you invest in the rising series of payments. In 1980, for example, when investors could have earned 13-15% on 10 year treasuries, many were buying stocks at a PE of 10, or an earnings yield of 10%, paying more for the cashflows from the more volatile instrument! So maybe the risk premium is a curve and looks more like:

No Risk    Risk Premium          Stock Earnings Yield          Stock P/E
0%          2.5%                      2.5%                                 40
1%          2%                         3%                                    33
2%          2%                         4%                                    25
3%          2%                         5%                                    20
4%          1.75%                    5.75%                               17.4
5%          1.5%                      6.5%                                 15.4
6%          1%                         7%                                    14.3
7%          0.5%                      7.5%                                 13.3

...with the risk premium going negative when investors' forecasts for future inflation reach a certain level, as occurred in my 1980 example. From what I've read, people in that era expected high inflation forever.

Instead of assuming different risk premiums at different nominal interest rates or in different inflation environments, perhaps the better way to look at this would be to look at "real" risk free rates rather than nominal ones?

The returns of stocks are much more volatile than, say, TIPS, but in principle the 30 year return of both in real terms should be independent of inflation, while a regular 30 year bond can essentially go to zero in a high inflation environment.

That's a good way of paraphrasing the idea that stock returns are inflation-adjusted in the very long run. However I can think of a couple of complications to a real risk free rate approach.

The real risk free rate of return is complicated. For example, with CPI and 9.1% and 10y yields at 2.77%, the real risk-free yield was -6.33% yesterday. By that logic, demand for treasuries should be zero and demand for TIPS and stocks should be through the roof because these at least have the potential to do better than -6.33% real. However, investors are obviously looking forward, and not at the present. They're locking in rates based on their expectations of the distant future. So a real-return method is necessarily looking at people's expectations, which change often. Witness, for example, how the entire bond market was flat-out wrong this time last year, because they expected inflation to be transitory. A simple risk premium model, in contrast, is envisioning a choice a future investor has to make about whether to buy treasuries yielding Y or stocks yielding Z, where Z can be predicted from Y. There's some benefit in the simplicity of modeling a real-time marketplace as opposed to what people will think about the future in the future. I.e. just as rising rates have reduced stock valuations in 2022, so will rising rates in the future, regardless of what people think is going to happen next.

I'm not saying looking at things from a real perspective is bad, just saying that for assets priced on the basis of future expectations like stocks and bonds, there's a lot in the measurement of real returns that is little more than investor expectations.

[wageslave23]

Its only one month of data, but wow July report was awesome!  Especially core CPI month over month! 

[Mr. Green]

Its only one month of data, but wow July report was awesome!  Especially core CPI month over month!

No surprise in a drop in fuel. Core CPI being unchanged month-over-month is a promising sign. Food is still really ugly though, over 10%, with Food at home still at 13%. The market is up significantly this morning, no doubt thinking this is a promising indicator that inflation has peaked and could come down fairly rapidly.

[ChpBstrd]

AUGUST
August CPI to be released 8/10: >8.5%
A recent Bloomberg survey of economists pinned the average consensus at about 8.7%
Economic data continues to be strong, but profit margins become compressed as retailers catch up with the PPI.

Actuals:
     CPI: 8.48%
     Core CPI: 5.91%

So my CPI forecast was a miss, but I think I was mostly correct about how Core CPI kept going strong as firms recoup from consumers some of the higher costs they've been paying as reflected in the PPI. My initial reaction is that I don't see anything here that will change my forecast of 0.75% hikes through the end of the year. However, this miss is a good time to check my assumptions and put together the strongest bull case I can imagine. I don't necessarily agree with the rationale below, but this is me trying to prove my own base case wrong:

MY BEST BULL CASE

FED VS. MY FORECASTS
When I've been wrong about predicting the Fed's actions, it has always been because I thought the data led to a logical conclusion and the Fed instead took a more dovish route. In late 2021, I assumed the Fed would do a surprise cessation of QE amid >4.5% CPI readings and was incorrect meeting after meeting. I was right about what they should have done, but wrong about what they did. Similarly, I was mildly optimistic that a larger QT would be announced in March, but instead we got a modest-sized QT package. Finally, in July when markets were expecting a 1% hike, I thought that made sense, but the Fed later talked it down and did 0.75%.

Maybe the lesson is that I'm significantly more hawkish and reactive than the Fed, regardless of whether I will turn out to be right or if the Fed will turn out to be right. In terms of calibrating expectations, I should start with my estimate of what should be done, and then dial it down to reflect what the most dovish committee I could imagine could get away with justifying. If the FOMC has resigned itself to accepting a recession, then they may see little incentive to jack up interest rates ahead of that recession, and thereby take the blame for overdoing it. By being as dovish as imaginable now, they can more easily defend their actions later. It's smart politics. Perhaps the FOMC is more forward-looking than me, and through their dovish stance they are actually managing the severity of the recession ahead rather than today's inflation.

The risk with such an attitude is obviously that a wage-price acceleration cycle could postpone the recession for a year or two, and then not even the doves can get away with doing less than 0.5% hikes throughout the first half of 2023. But even in that scenario, stocks could experience the classic pre-recession burn-up before they burn-out because, as I stated above in a bearish context, policy is still stimulative when loans can be had for less than the rate of inflation.

INFLATION
The prices of wheat and crude oil are now back to where they were before the invasion of Ukraine. So much for the permanent reduction in supply everyone was talking about last spring.
https://tradingeconomics.com/commodity/wheat
https://tradingeconomics.com/commodity/crude-oil

What happens to inflation if such trends continue? Now that the yield curve is heavily inverted, speculators should be thinking about closing their long futures across commodities markets, to ensure they aren't caught long in the coming recession. That's why the trend will continue.

Increasing layoffs and a steady rise in Initial Claims could be the death rattle for this inflationary cycle. S&P500 earnings have already declined, and companies are looking at cost-cutting measures to get back on track to meet their profitability goals. If workers are losing the negotiating power and job-hopping options they had for the past year, then wages might go stagnant from here. Job-hoppers will additionally be discouraged if they expect a recession on the way, and don't want to lose seniority. Considering how low the savings rate is, we might have a holiday season that's less about shopping and more about hunkering down, which would mean big clearances considering how high inventories are. In a nutshell, with savings so low, who is going to buy record-level inventories? At what point have consumers pulled ahead all the purchases they're going to pull ahead?
https://fred.stlouisfed.org/series/PSAVERT
https://fred.stlouisfed.org/series/BUSINV

VALUATIONS
Stocks are perceived as offering inflation-adjusted returns in the long run. If we have a dovish FOMC that will keep corporate borrowing rates lower than the rate of inflation, potentially for the next year or more, then companies will be raising prices faster than their interest costs increase. That translates into profits and is another example of how policy remains stimulative.

In this light, perhaps buying Apple for a PE of 27, Alphabet for a PE of 22.4, Pfizer for a PE under ten, or banks for single-digit PEs will work out. Maybe small or mid-caps with PE's in the 12-13 range are a bargain, and maybe value stocks with a PE of 14 are reasonable ways to attain positive real returns in a world where IG bonds will continue to deliver negative real returns. Stated another way, if the FOMC plans to keep rates lower than inflation for the next year or so, then There Is No Alternative still applies in terms of positive real yields.
https://www.yardeni.com/pub/stockmktperatio.pdf
https://www.yardeni.com/pub/corporatebonds.pdf

BUT... RECESSION?

It's too simplistic to think recession = 30% loss, and 2/10 yield curve inversion = recession, so therefore run away from stocks when the yield curve inverts. If the last four recessions are any guide, stocks made massive returns in the time between yield curve inversion and recession. If the rationale has been that the economy heats up prior to a recession and goes full steam until being extinguished by rate hikes, then the bullish rationale is even stronger if the FOMC is going to keep the FFR below CPI for a prolonged period of time. This might strike some as a game of musical chairs, but there's no excuse not to try hedged positions or value stocks now.

[PDXTabs]

Its only one month of data, but wow July report was awesome!  Especially core CPI month over month!

This report is interesting with regard to how the average consumer will see things vs wall street and the Fed. In particular, food is up a lot and people who shop for groceries notice.

The food index increased 1.1 percent in July; this was the seventh consecutive monthly increase of
0.9 percent or more. The food at home index rose 1.3 percent in July as all six major grocery store
food group indexes increased. The index for nonalcoholic beverages rose the most, increasing 2.3
percent as the index for coffee rose 3.5 percent. The index for other food at home rose 1.8 percent,
as did the index for cereals and bakery products. The index for dairy and related products
increased 1.7 percent over the month. The index for meats, poultry, fish, and eggs rose 0.5 percent
in July after declining in June. The index for fruits and vegetables also increased 0.5 percent
over the month.
...
The food at home index rose 13.1 percent over the last 12 months, the largest 12-month increase
since the period ending March 1979. The index for other food at home rose 15.8 percent and the
index for cereals and bakery products increased 15.0 percent over the year. The remaining major
grocery store food groups posted increases ranging from 9.3 percent (fruits and vegetables) to 14.9
percent (dairy and related products). - https://www.bls.gov/news.release/cpi.nr0.htm

But my stonks are up so I'm not complaining.

[ChpBstrd]

Wow, the Producer Price Index numbers released today show outright disinflation.





Part of me says this is just a result of the recent commodities dip. Another part of me says it's a sign that the blip in producer prices might not translate to consumer prices, especially as inventories sit above trend:



My existing narrative has not been debunked in any way, and I could fully explain these results by simply saying commodities corrected between mid-June and now. Policy is still net-stimulative, and lower commodities prices have merely postponed the day when recession saves us from inflation, and made a longer series of rate hikes even more likely.

However the evidence also supports an alternative narrative in which a commodities bubble was pushing up inflation, that bubble has popped, and now food and energy prices are heading down. Because no speculators want to get caught in a futures contract when the recession starts, they will continue to flee commodities, and core CPI growth could fall a quarter to a half percent per month for the rest of the year. This would align with the bond market's expectation that inflation will be low enough to stop the rate hikes later this year. In this narrative, stocks rally for the next 12-18 months and then tank as the recession hits.

There's enough upside risk that I'm going to capitulate and enter collared positions or long calls. However I'll be watching commodities closely, because inflation seems to be very sensitive to them. The right calls, in hindsight, were to go long or short the market in the days before the CPI announcements based on the direction of the GSCI Commodities Index. Investors are being surprised by CPI/PPI results when in fact those numbers were being predicted by commodities data that are available on a daily basis.

[dividendman]

Part of me says this is just a result of the recent commodities dip. Another part of me says it's a sign that the blip in producer prices might not translate to consumer prices, especially as inventories sit above trend:

Doesn't the increasing inventories prices mean producer prices are likely to continue downward?

I think that due to 1) consumer debt levels increasing pretty rapidly, 2) producer prices declining, 3) inventories rising and 4) commodities declining

we can expect:

a) Consumers to lower spending due to maxing out on debt (especially since the home equity credit card limit is declining in a lot of markets) and no more stimulus
b) 2, 3, and 4 above to continue due to consumers having less money
c) Recession/earnings misses across the Christmas season, lots of layoffs etc.
d) Inflation to plummet

Of course, I don't act on any of this :)

I do enjoy reading your analyses though ChpBstrd!

[ChpBstrd]

Part of me says this is just a result of the recent commodities dip. Another part of me says it's a sign that the blip in producer prices might not translate to consumer prices, especially as inventories sit above trend:

Doesn't the increasing inventories prices mean producer prices are likely to continue downward?

I think that due to 1) consumer debt levels increasing pretty rapidly, 2) producer prices declining, 3) inventories rising and 4) commodities declining

we can expect:

a) Consumers to lower spending due to maxing out on debt (especially since the home equity credit card limit is declining in a lot of markets) and no more stimulus
b) 2, 3, and 4 above to continue due to consumers having less money
c) Recession/earnings misses across the Christmas season, lots of layoffs etc.
d) Inflation to plummet

Of course, I don't act on any of this :)

I do enjoy reading your analyses though ChpBstrd!

Thanks. That's a good summary of my alternate hypothesis, which is the stock and bond market consensus.

There are also the following feedbacks:

1) Reduced demand for fresh inventory from retailers reduces demand for commodities, pushing down commodities prices even as inventories are clearanced.
2) Falling or stable prices for things like food and gas increase consumer demand.
3) Rising consumer demand eventually creates demand for inventory and commodities...

So there is a cyclical feedback that could keep the economy growing for a long time still.

Also, consumers might not actually be in bad shape. The cost of debt service as a % of disposable income is lower than it was during any of the boom years of 2012-2019, and way below the boom years of the 90's. All those locked-in <4% mortgages are an economic boost that could last for decades.



And the net worth of households is close to all-time highs, despite our gloom. The growing inequality of wealth is a big caveat, of course, but the data speak good news.



For all these reasons, I have a certain distrust for the market consensus for a recession starting in the 4th quarter of 2022. That's a very unusually short period of time between yield curve inversion / rate hikes and the recession. The only other time things flipped that fast was 2020, and it took lockdowns and death on a massive scale to achieve a recession only a few months after yield curve inversion. Had COVID not hit, signs suggest we'd have been looking at a recession in Q42020 or early 2021.

Additionally, the market's expectations are inconsistent with today's prices. Stock prices tend to fall HARD during recessions. So why are people bidding up stocks in hopeful anticipation of an end to the rate hikes? Do they all plan to sell in October or November, having timed the market correctly? If a recession is coming in Q4, you should short the market, not go long. I'm just not so sure that recession is coming so soon.

[EscapeVelocity2020]

There are a lot of forces in place to bring oil and natural gas prices back up headed in to year end (OPEC is at maximum output, natural gas price has decoupled from oil, US is tapping the strategic reserve going in to November elections, recession fears receding/Fed policy remaining stimulative longer).  You might be a bit too early in capitulating, but I understand that these last 2 weeks have been pretty hard to ignore.  The NASDAQ is technically back in to a bull market (up 20%), although still down 18% for the year...  Wild times!

Personally, I'm awfully tempted to pick up some VDE for the 3% yield and upside potential.  Natural gas prices are going to be bonkers and companies are returning the excess cashflow to shareholders.

[MustacheAndaHalf]

For all these reasons, I have a certain distrust for the market consensus for a recession starting in the 4th quarter of 2022.

The timing of recession, if any, is the single most important piece of information for the stock and bond markets right now.  Yet I suspect you haven't double checked what you said here - do you have data to back this up?  Why do you think market consensus is "4th quarter of 2022"?

I searched for recession expectations, and found Bloomberg's survey of economists from mid July.  Less than half (47%) expect recession in the next 12 months, and those 12 months are split evenly between this year (2022 q3,q4) and next year (2023 q1,q2).  Put that together, it means a fraction of 47% expect a recession this year, not a majority.  That's from a survey of eonomists, so the market may have other views.
https://www.bloomberg.com/news/articles/2022-07-15/odds-of-us-recession-within-next-year-near-50-survey-shows

What data shows the market consensus for a recession?

[Viking Thor]

Here is a survey from Schwab of their investors.

Most expect a recession (71% thinks its likely \ highly likely)
https://pressroom.aboutschwab.com/press-releases/press-release/2022/Schwab-Q3-Trader-Sentiment-Survey-Most-Traders-See-a-Recession-Beginning-This-Year/default.aspx

[MustacheAndaHalf]

I think my comment about recession was wrong - inflation is the top concern in markets, and especially how it changes.  Being in a recession may change Fed and investor behavior less than I expect.

Also from Schwab's survey of customers who are active traders (link in Viking Thor's post):
"Inflation remains the top concern around money and investing for traders (21%), but most think it will ease by the end of 2023 (79%)."

And by "traders", they mean:
"The Charles Schwab Trader Sentiment Survey is a quarterly study exploring the outlooks, expectations, trading patterns and points of view of active traders at Charles Schwab and TD Ameritrade — defined as those making more than 80 equity trades, more than 12 options trades, or those who make futures or forex trades over the course of the year. The study included 968 Active Trader clients at Charles Schwab and TD Ameritrade between the ages of 18-75 and was fielded from July 6-18, 2022."

[EscapeVelocity2020]

I know this is just one small data point, but today's first economic report was pretty wild - New York Empire State factory gauge plunges in August deep into contraction territory

The New York Fed’s Empire State business conditions index, a gauge of manufacturing activity in the state, plummeted 42.4 points to negative 31.3 in August, the regional Fed bank said Monday.

This is the second largest monthly decline on record and among the lowest levels in the survey’s history, the regional Fed bank said.
Economists had expected a reading of 5.0, according to a survey by The Wall Street Journal.
Any reading below zero indicates deteriorating conditions.

Oil is taking a beating today on reports of China's economy slowing.  If I were a contrarian, today would be a good entry point in to VED, but I just don't need to add trading stress and market angst in to my life.  If we really do head in to a global recession, VED will take a pounding.  Just enjoying following all of this crazy data and trying to figure out who is right - JPMorgan Says the Stock Rally Has Legs. Morgan Stanley Disagrees

[ChpBstrd]

For all these reasons, I have a certain distrust for the market consensus for a recession starting in the 4th quarter of 2022.

The timing of recession, if any, is the single most important piece of information for the stock and bond markets right now.  Yet I suspect you haven't double checked what you said here - do you have data to back this up?  Why do you think market consensus is "4th quarter of 2022"?

I searched for recession expectations, and found Bloomberg's survey of economists from mid July.  Less than half (47%) expect recession in the next 12 months, and those 12 months are split evenly between this year (2022 q3,q4) and next year (2023 q1,q2).  Put that together, it means a fraction of 47% expect a recession this year, not a majority.  That's from a survey of eonomists, so the market may have other views.
https://www.bloomberg.com/news/articles/2022-07-15/odds-of-us-recession-within-next-year-near-50-survey-shows

What data shows the market consensus for a recession?

1) The CME FedWatch tool shows market participants expecting the Federal Funds Rate to peak at 3.5%-3.75% in December, and stay there until the summer of 2023. This market says something happens in the October/November timeframe that causes the rate hikes to suddenly stop. I interpret that cause as recession, but I suppose an alternative belief is that transitory inflation could fall all on its own despite a healthy economy. However, even if we accept this transitory interpretation, how do we go from 8.5% CPI to maybe 2.5% in August-November? What would cause commodities and wage pressures to collapse that fast, other than a recession? https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

2) The S&P500's ttm PE ratio of 21.5 represents an earnings yield of (1/21.5=) 4.65%. If treasury yields were expected to get close to this yield, then they'd probably be a better deal because safe investments are expected to yield less than risky investments. I don't think people buying stocks at these prices expect that they'll get the opportunity to buy 10-year treasuries yielding 4.5%-5% a few months from now. https://www.multpl.com/s-p-500-pe-ratio

3) The inverted yield curve. Currently the 6-month through 3 year yields are lower than the yield on 10-year treasuries. This doesn't generally happen unless a recession is on the way within the next couple of years. https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value_month=202208

So my interpretation is that economists and markets seem to disagree. Even if the economists said there is a 47.5% chance of recession between early July 2022 and early July 2023, the market's position is that the recession starts in three months (if not now). History is on the side of the economists: yield curve inversions precede a recession by an average of 18 months, so if during an inversion you ask an economist the odds of the recession coming within 12 months, 47.5% might be a reasonable to high ballpark estimate depending on the distribution of historical outcomes. Markets predicting a recession within the next 3 months, however, have the following argument in their favor:

https://www.reuters.com/markets/us/deep-us-curve-inversion-hastens-recession-it-predicts-mcgeever-2022-08-10/

The extent of the yield curve inversion is expected to become deeper than it was in 2000. This author thinks the depth of the yield curve inversion means banks will be less likely to make loans (essentially borrowing at the short end of the curve and lending a the long end). A deeper inversion means the business of making loans becomes unprofitable faster. Banks will try to tighten their lending standards at the last minute to reduce their losses.

The economists could retort that the National Financial Conditions Index has actually shown a relief in stress for debt markets since about early July, not a tightening. We're still in below-zero territory, rather than the above-zero conditions associated with recession.

https://fred.stlouisfed.org/series/NFCI

So if you side with the economists who think the recession will probably start in the 2nd half of 2023, then you should expect inflation to remain a problem later this year and you should expect the FFR to blow past 4%. This is an outcome markets are literally calling impossible. If you side with the markets, then you should expect the onset of a sudden and deep recession in the 4th quarter of this year that puts an end to any chatter about additional rate hikes.

These dueling predictions strike me as a no-win scenario for stocks. If the economists are right, then rate hikes will discount stocks enormously, and that's before the impact from the eventual recession itself! If the market is right, then stocks are heading into the sort of recessionary scenario that leads to 20-40% losses. People in the market are demanding 10 year yields and 30 year yields (!!!) lower than 6-month yields because they think these yields are the best it's going to get, and rate cuts are in our near future. Such bets will be regrettable if the economists are right and recession takes a while to arrive.

Already, the CME FedWatch tool shows expectations have shifted to a 0.5% rate hike in September instead of a 0.75% hike! And this is supposed to happen after unanimous consent on the July 0.75% hike and numerous hawkish comments. I personally think it's more likely the market is in for a surprise.

[less4success]

2) The S&P500's ttm PE ratio of 21.5 represents an earnings yield of (1/21.5=) 4.65%. If treasury yields were expected to get close to this yield, then they'd probably be a better deal because safe investments are expected to yield less than risky investments. I don't think people buying stocks at these prices expect that they'll get the opportunity to buy 10-year treasuries yielding 4.5%-5% a few months from now. https://www.multpl.com/s-p-500-pe-ratio

Could this finally be the "dumb index fund money breaks the market" problem that people have been wringing their hands over for a long time? I know I completely ignored valuations when dollar cost-averaging into the market over my working career.

Maybe most of the active investors have already pulled their money out and now we're left with index fund lemmings? Is that plausible? I have no idea how to decide!

(Note: all the "dumb money" and "lemming" comments are not meant to be mocking--I'd be doing the same thing if I had a positive savings rate! I also don't put much stock into this theory, but at some point index flows--and to a much lesser extent, and for an actually dumb reason, superstonks disciples--could certainly mess with valuations.)

[wageslave23]

2) The S&P500's ttm PE ratio of 21.5 represents an earnings yield of (1/21.5=) 4.65%. If treasury yields were expected to get close to this yield, then they'd probably be a better deal because safe investments are expected to yield less than risky investments. I don't think people buying stocks at these prices expect that they'll get the opportunity to buy 10-year treasuries yielding 4.5%-5% a few months from now. https://www.multpl.com/s-p-500-pe-ratio

Could this finally be the "dumb index fund money breaks the market" problem that people have been wringing their hands over for a long time? I know I completely ignored valuations when dollar cost-averaging into the market over my working career.

Maybe most of the active investors have already pulled their money out and now we're left with index fund lemmings? Is that plausible? I have no idea how to decide!

(Note: all the "dumb money" and "lemming" comments are not meant to be mocking--I'd be doing the same thing if I had a positive savings rate! I also don't put much stock into this theory, but at some point index flows--and to a much lesser extent, and for an actually dumb reason, superstonks disciples--could certainly mess with valuations.)

Earnings can increase.

[ChpBstrd]

2) The S&P500's ttm PE ratio of 21.5 represents an earnings yield of (1/21.5=) 4.65%. If treasury yields were expected to get close to this yield, then they'd probably be a better deal because safe investments are expected to yield less than risky investments. I don't think people buying stocks at these prices expect that they'll get the opportunity to buy 10-year treasuries yielding 4.5%-5% a few months from now. https://www.multpl.com/s-p-500-pe-ratio

Could this finally be the "dumb index fund money breaks the market" problem that people have been wringing their hands over for a long time? I know I completely ignored valuations when dollar cost-averaging into the market over my working career.

Maybe most of the active investors have already pulled their money out and now we're left with index fund lemmings? Is that plausible? I have no idea how to decide!

(Note: all the "dumb money" and "lemming" comments are not meant to be mocking--I'd be doing the same thing if I had a positive savings rate! I also don't put much stock into this theory, but at some point index flows--and to a much lesser extent, and for an actually dumb reason, superstonks disciples--could certainly mess with valuations.)

Earnings can increase.

Yes, stock valuation is always a moving target, and is always based on forecasts more so than the trailing-twelve-months. Every day we get a trickle of earnings information from individual companies that changes their valuation metrics overnight, and changes the indices' valuation metrics too. Still, it seems weird for stock investors to get excited about a growth trend when companies' interest expenses are rising and when the yield curve forecasts a recession. But the prospect of earnings growing for another year or two before the recession hits creates the temptation to believe one can capture that earnings growth and get out before stock prices fall.

Different opinions can be expressed by the flow of investor dollars into different markets, and those markets can be flat wrong, as was the bond market in 2021. That's the caveat with market-based pieces of "evidence" like the yield curve, the FedWatch tool, inflation breakevens, market rallies, etc. The "lemmings" create a self-referential cycle when they look at statistics created by their own behavior and use it to justify more of the same behavior. That's why I'm leaning more toward history, facts, and theory in my attempts to predict the future. Information like the history of yield curve inversions, inventories, initial claims, and the Taylor rule come from outside the realm of herd behavior. Ideally, I like to contrast the non-herd information with the herd information.

[MustacheAndaHalf]

@ChpBstrd - A lot to unpack in your post, so I'll focus on (1) peak interest rates and (3) yield curve inversion.

Easiest first, actually a yield curve inversion rarely marks the immediate start of a recession.  The data I've seen shows it starting 12-24 months later, not 6 months later.  The yield curve inversion supports a recession happening later than 2022.

With (1), I think this is the Fed, not a recession.  At the last Fed meeting, the market was pleased to find the Fed's data seemed to line up almost exactly with market expectations. The market was predicting a few 0.75% rate hikes, then 0.50% and finally 0.25%.  The Fed would taper rate hikes until reaching a "neutral rate" (which is hotly debated) later this year.  So I think the peak interest rate is the Fed attempting a soft landing, and is not related to recession.

The Fed's priority is inflation.  Let's say we're already in a recession by all measures.  That does not mean the Fed needs to lower rates - it's too soon for that.  The Fed's priority remains inflation, and recession may be an unfortunately side effect of fighting inflation.  If inflation remains high, again baffling the peak inflation camp, then the peak inflation expectations will rise again.

[ChpBstrd]

@ChpBstrd - A lot to unpack in your post, so I'll focus on (1) peak interest rates and (3) yield curve inversion.

Easiest first, actually a yield curve inversion rarely marks the immediate start of a recession.  The data I've seen shows it starting 12-24 months later, not 6 months later.  The yield curve inversion supports a recession happening later than 2022.

With (1), I think this is the Fed, not a recession.  At the last Fed meeting, the market was pleased to find the Fed's data seemed to line up almost exactly with market expectations. The market was predicting a few 0.75% rate hikes, then 0.50% and finally 0.25%.  The Fed would taper rate hikes until reaching a "neutral rate" (which is hotly debated) later this year.  So I think the peak interest rate is the Fed attempting a soft landing, and is not related to recession.

The Fed's priority is inflation.  Let's say we're already in a recession by all measures.  That does not mean the Fed needs to lower rates - it's too soon for that.  The Fed's priority remains inflation, and recession may be an unfortunately side effect of fighting inflation.  If inflation remains high, again baffling the peak inflation camp, then the peak inflation expectations will rise again.

The yield curve reflects a market expectation for future rate cuts in the coming months/years, and the Federal Funds Rate futures reflect that market's expectation that something will occur that ends this cycle of rate hikes. You're right that we have to remain open-minded to the idea rate hikes could be ended by something other than an immediate recession, such as an insufferably dovish Fed or a narrative that there is no need to hike rates further because inflation is falling on its own, or scary disinflationary data and events.

However, one really has to dig into financial history to find a similar case where CPI growth exceeded 9%, then fell back down to a sustainable range in a very short time, and a recession did not occur.

The short-lived 1950-52 bout of inflation is the closest we've ever come to bringing 9+% inflation down within roughly a year and not having a recession. An 11-month recession started in July of 1953, but that is a good distance away from peak inflation in April 1951, so one might argue for the separation of the two events. If our own peak inflation occurred in June 2022, an equivalent 27-month time frame would put a recession starting in about September 2024 and ending in the summer of 2025. Would that be due to rate hikes that occurred in 2022?



Another argument for separating the 1951 inflation episode from the recession is that rate hikes essentially did not occur at that time, and inflation still fell. According to multpl.com the 10 year treasury yield was 2.3% on 1/1/1950, 2.57% on 1/1/1951, and 2.68% on 1/1/1952. Historical accounts say that the Fed manipulated bank reserve ratios through asset purchases.

Narrative explanations for post-war inflation are provided by numerous sources. The gist is that sometimes inflation can self-correct without a Paul Volker level response.

https://www.employamerica.org/researchreports/expecting-inflation-the-case-of-the-1950s/
https://www.whitehouse.gov/cea/written-materials/2021/07/06/historical-parallels-to-todays-inflationary-episode/
https://www.guggenheiminvestments.com/perspectives/global-cio-outlook/lessons-fighting-inflation-skip-over-volcker-1946 (a money-supply focused explanation)

Today's pundits pointing to the 1970s are the inflation hawks who are concerned that a lack of action will lead to a wage-price spiral. Those pointing to the late 1940's - early 1950's are team transitory, which is mostly concerned that Fed rate hikes will unnecessarily plunge the economy into an avoidable recession.

I struggle to create a narrative for inflation falling on its own without leading to recession, but it goes something like this: China will eventually end its zero-COVID policy, supply chains are sorted out after two years of disruption, the commodities bubble collapses as speculators are spooked by the yield curve and as commodities producers expand supply, unemployment bumps up a half percent or so, and slightly tighter lending standards as illustrated by the NFCI reins in over-investment while not going too far. Meanwhile, over-inventoried retailers cut back on their purchases and mark down prices, while consumers afraid of a recession increase their savings rates.

This modern version of the post-war saga does not involve the sudden relief of wartime price controls, a Korean war leading to consumer hoarding followed by relief when price controls didn't appear, the sudden floating of t-bill rates, or a Fed-Treasury Accord shaking up the landscape. The modern world also involves new things like manipulation of short term rates through overnight markets rather than bank reserve ratios, quantitative tightening, a dual mandate, and more data than anyone can comprehend at once.

The postwar inflation episodes were resolved or self-resolved with relatively minimal intervention, and an economic boom followed. However, when policy makers in the 1970s tried to follow the template in a similar way as worked in the 50's, a massive outbreak of inflation occurred. Of course, a lot more was going on in the 1970s that wasn't occurring in the 1950s, such as Nixonian price controls, the doubling of oil prices, and the end of the gold standard. We've had an activist Fed ever since, but criticism of the Fed may be starting to stick after a generation of asset bubbles, financial crises, and recessions following rate hikes. The Fed's shift from an "inflation rate target" to an "average inflation rate target", and Powell's comment about letting inflation run hot for a while suggests a desire to be less reactive to potentially short trends and more like the lackadaisical 1950's Fed. 

If the differences in the details between the 1950s and 1970s made the difference between transitory inflation and a lost decade, then what do we make of today's differences with those historical eras fifty and seventy years ago? Is no historical template a close enough fit for us to confidently say we know anything about what happens next? And let's not forget the low-inflation 2010's, an era that confounded all the models. Maybe the FOMC's delays and modest actions in response to soaring inflation reflect their uncertainty and humility. They are without a reliable model to predict the effects of policy, and so they are proceeding with relative caution because that's better than being theoretically confident (and wrong) like Andrew Mellon or Arthur Burns.

[MustacheAndaHalf]

I think there was also a mild recession in the early 1990s, which I haven't looked at in detail.  I've seen it cited by those who believe a soft landing is possible.

I'm still on break from active investing.  I don't recall hearing the 1950s example when I was investing actively.  If I heard that from several professional investors, and thought it represented a significant view in the markets, I would study it in more detail.  I might look for data on when the yield curve inverted, the timing of rate yikes, and start/end of recession.

Also worth noting that recessions are marked retroactively.  The first few months an economy goes into recession, usually nobody knows it.  It requires looking at data after the fact to point to the start of a recession.  So there's some number of months where a recession technically had started, but it was still uncertain to investors at the time.

[ChpBstrd]

Here’s a good explanation from economist Campbell Harvey about why it is technically nearly impossible for CPI to fall below about 7% by the end of this year.

1) The months being dropped from the annualized average are lower-inflation months.
2) Rent - a big component - does not go up for everyone at once. It goes up when leases renew. So there are average rent increases ahead as leases catch up with the new prices. We’re we using 1980’s methods of calculation, CPI would be 12%+.

https://youtu.be/75tMVl3FQHc

This is an argument against those who think a rapid fall in CPI will occur by EOY.

[EscapeVelocity2020]

ChpBstrd - that was a nice video clearly explaining where CPI is likely headed.  Here is a video (https://youtu.be/zxwO4xw4CZ0) giving some history on inflation theories of the past as well as shortcomings in the current models that are struggling to explain both why inflation remained low when central bankers increased the money supply but then spiked although inflation expectations should have remained constant.  Basically, why their predictions (remember 'transitory inflation'?) were wrong.

I liked the modest inflation theory at the conclusion that, basically, economists will likely never come up with a simple theory of inflation.  Although certain correlations are relatively well-known, in the same way that it is known that smoking causes cancer, it is impossible to know exactly if and when the cancer will appear.  Got me to appreciate the predicament the Fed is currently in.  The markets are supremely confident that the Fed has everything under control and are willing to load up on risk.  All the Fed really knows are general correlations between causes of inflation and consequences, but it is unpredictable as to how much inflation we will experience and which combination of factors will best bring inflation back down (without simply blowing up the economy).

[ChpBstrd]

@EscapeVelocity2020 that's a good overview of the uncertainty and lack of a working model we're dealing with now. The lack of a working model after all these decades may be why we have a Fed focused on moving slowly enough not to be blamed for breaking things rather than actual targets. In general, I think our economic theories are oversimplifications, an actual working theory would be too complicated for most human brains to comprehend. Such an actual working theory would become obsolete quickly due to the rapid pace of change in the structure of the economy. E.g. globalization and de-globalization, electrification of transportation, etc. I suspect the best we can do is forecast the impact of specific changes.

One thing I'd like to point out from the video is how higher inflation expectations will lead to more credit creation. This is the macro idea behind all the gloating on the Don't Payoff Your Mortgage Thread on this board. As a business, you want to take on debt now if the prices of the products you produce using that debt will rise in the future, and the interest rate you are charged for debt in the future will increase. That's basic arbitrage. As a consumer, you want to take on debt now so that you can pull forward your consumption and avoid future price hikes. To illustrate, suppose I can take out a loan at 3% to buy $1M worth of equipment and I can sell the equipment in one year for a 7% higher price. It makes sense to do so.

However, in line with low expectations for 5-year breakeven inflation rates, we're not seeing the growth of M3 exceed the growth of M1 like it apparently did in the late 1970s. Inflationary expectations have clearly not become entrenched. However, consumers are still spending almost their entire paycheck, as evidenced by the savings rate.





How long until sentiment shifts? Could the savings rate go negative if there was a rush to obtain debt for less than the cost of inflation and lock in purchases? Or must the savings rate eventually revert to the norms from pre-pandemic years, implying a collapse of demand - especially once consumers have pulled forward so many purchases? I still can't get past the idea that the first scenario involves a lot more rate hikes than are currently priced into markets, and the second scenario involves a massive reduction in earnings, earnings forecasts, and stock valuations. It seems very lose-lose.

[MustacheAndaHalf]

Here’s a good explanation from economist Campbell Harvey about why it is technically nearly impossible for CPI to fall below about 7% by the end of this year.
https://youtu.be/75tMVl3FQHc

My new approach is to very briefly check out the person who is providing their view first.  Looking at Wikipedia, he seems to have various contributions as an economist, some related to investing.  Thanks for the information from a high quality source.

I would have liked to see a devil's advocate argument about how -3% inflation could occur in the next couple CPI prints, however unlikely.  Could grain shipments from Ukraine drive down food prices enough to turn inflation negative overall?  Seems unlikely when compared to the larger allocation to shelter that is still rising, but I'd still like to see it.  Maybe I need to look at the views of other economists.

But with this information in mind, September looks set to surprise people.

[ChpBstrd]

My new approach is to very briefly check out the person who is providing their view first.  Looking at Wikipedia, he seems to have various contributions as an economist, some related to investing.  Thanks for the information from a high quality source.

I would have liked to see a devil's advocate argument about how -3% inflation could occur in the next couple CPI prints, however unlikely.  Could grain shipments from Ukraine drive down food prices enough to turn inflation negative overall?  Seems unlikely when compared to the larger allocation to shelter that is still rising, but I'd still like to see it.  Maybe I need to look at the views of other economists.

But with this information in mind, September looks set to surprise people.

This brings up a tough question: To what extent do we disregard a messenger due to their personal history or lack thereof? Obviously, YouTube is full of fake information, some of which can literally kill you, so for example we should always get our medical advice from our doctors, not some YT influencer trying to earn cash from clicks or by selling dangerous unregulated "supplements". Similarly there are people selling false narratives of history, science, civics, mental health, investing, or their opponents' political positions. Social media allows them to earn an easy living or side gig doing a couple of videos per week. In theory, the argument from authority is a fallacy, but in practice, actual experts are presented alongside absolute trash on YT, and the temptation is to separate the wheat from the chaff.

As we've seen, economics is operating without a working theory of inflation at the moment. With that in mind, does a professor with 30 years' tenure, ~100 publications, and various awards on the wall (like Campbell Harvey) really have so much more knowledge that we should ignore the opinion of someone who claims to be a grad student? Should our tolerance for low qualifications be higher for an emerging field like econ than for, say, cancer treatment or history? What about all the YT'ers with fake information about economics "they don't want you to know about" such as the people claiming U.S. inflation stats are made up to help elected politicians?

So maybe a good information assessment process is:

1) Is the idea internally coherent and consistent with everything else we know? E.g. a claim that gasoline inflation has been 15% for each of the last 10 years can be debunked by simple math and awareness of past prices.

2) Does the idea conflict with the way experts see the subject? E.g. a claim that rosemary cures cancer conflicts with medical professionals' understanding of cancer treatment.

3) Is the source credible? This can be hard to verify. Anyone can present themselves as a PhD or an MD online. Or they can just take the name of a real person, make the YT video, and off they go. Then there's the problem of deepfakes and simple audio dubbing, where a real person can be made to say anything. Furthermore, credible people and institutions can lose their credibility, as people of a certain age observed with the History Channel and as we observed during the pandemic with horse de-wormer. At best, all we can do with this step is disregard the clickbait and entertainment-oriented stuff.

Believe too many falsehoods - even about areas of professional uncertainty - and it'll have a detrimental effect on your life.

To the point about the other side of the argument... the people expecting the FFR to peak at <4% seem to be creating their own evidence by buying investments, setting the yield curve, and speculating in the futures markets rather than talking on the internet. I'm really not hearing a lot of chatter about why rates are going to stop rising, other than that markets expect them to stop rising. There are the usual recession doomsayers, but it's weird for the market to have such a specific prediction and no narrative being pushed in the media. This silence more than anything is what's driving me to more carefully analyze the plausibility of the market's prediction.

[SpaceCow]

Already, the CME FedWatch tool shows expectations have shifted to a 0.5% rate hike in September instead of a 0.75% hike! And this is supposed to happen after unanimous consent on the July 0.75% hike and numerous hawkish comments. I personally think it's more likely the market is in for a surprise.

It's now show 65.5% for a 50bps hike in September. Despite the reduced jobless claim numbers released today. This seems crazy to me! I think the CPI/PCE would have to come in substantially low, and the labor market would have to suddenly and dramatically cool off before the Fed would entertain a 0.5% hike

[ChpBstrd]

Already, the CME FedWatch tool shows expectations have shifted to a 0.5% rate hike in September instead of a 0.75% hike! And this is supposed to happen after unanimous consent on the July 0.75% hike and numerous hawkish comments. I personally think it's more likely the market is in for a surprise.

It's now show 65.5% for a 50bps hike in September. Despite the reduced jobless claim numbers released today. This seems crazy to me! I think the CPI/PCE would have to come in substantially low, and the labor market would have to suddenly and dramatically cool off before the Fed would entertain a 0.5% hike

It may be crazy, but we need to consider that the Fed probably doesn't think like us.

1) What if the FOMC, after looking at market-based metrics, agrees with the markets that they have already engineered a recession sufficient to reduce inflation to their target range? A recent survey of 70 CEOs found that 97% believe we're either already in a recession or going into one within 18 months. That's an eye-opening level of unanimity, and in conjunction with the recent New York Fed manufacturing report suggests a rapid pullback in capital / tech spending.  It puts the Fed under pressure not to make the recession worse. 
https://finance.yahoo.com/news/97-of-execs-say-were-in-a-recession-or-headed-toward-one-stifel-survey-finds-133200291.html
https://seekingalpha.com/article/4534724-empire-collapses

2) What if the FOMC does dial back their rate hikes because they are looking at monthly numbers instead of the annualized number. When we flip the CPI chart into a percent change per month chart instead of percent change from a year ago, it looks like inflation fell off a cliff and hit zero. If commodities stay under control and the August numbers look like July, there's a defensible case to be made for 0.5%.



I'm afraid to go bearish at the moment, despite piles of evidence that consumtion is strong and inflation is going to continue running hot, because markets and the Fed can manufacture their own rally. A dovish Fed and markets that think we're already partway through the recession equals rising stock prices. Even if it is a false bottom, short positions can be massacred for the next two or three months for no better reason than everyone was feeling mistakenly bullish at the time. I've thought about doing way-out spreads with expirations several months away, but I don't yet have enough certainty to be so bold. If earnings continue to hold up while the Fed dials back rate cuts and CEOs slash spending... well... that's the scenario traders are betting on now.