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

[ChpBstrd]

Yea so much for my day trade bragging. I'll give myself a good snap with the rubber band around my wrist and move on. The best explanation I've seen is this:

The S&P 500, at its low, had retraced half the gain it had made from the Covid low in 2000 to its peak in January 2022. That’s an important level for market technicians, and when it was hit, it appeared to set off a wave of profit-taking in put options that had become profitable, according to Bloomberg, which translated into actual buying, especially as those who were short the market got squeezed. And the rest, as they say, is history.

It’s an unsatisfying reason, especially in the midst of a bear market, and everyone looking for a narrative that could help reverse the painful losses. But sometimes markets move more because of positioning and trading, not for any fundamental reason.

Sometimes, even a 3% gain is just noise.

[blue_green_sparks]

Yea so much for my day trade bragging. I'll give myself a good snap with the rubber band around my wrist and move on. The best explanation I've seen is this:

The S&P 500, at its low, had retraced half the gain it had made from the Covid low in 2000 to its peak in January 2022. That’s an important level for market technicians, and when it was hit, it appeared to set off a wave of profit-taking in put options that had become profitable, according to Bloomberg, which translated into actual buying, especially as those who were short the market got squeezed. And the rest, as they say, is history.

It’s an unsatisfying reason, especially in the midst of a bear market, and everyone looking for a narrative that could help reverse the painful losses. But sometimes markets move more because of positioning and trading, not for any fundamental reason.

Sometimes, even a 3% gain is just noise.

Back in the pre-covid bull market I would day-trade SPY on the long side with 50 or 100K from 9:45 to 10:30 AM, usually getting out within 5-10 minutes with a few hundred netted each morning. It was fun and easy and when I got stuck, I could always wait a day or two to get back out. Not doing that now.

[ChpBstrd]

All my losses and then some came back today. I even wrote some 0.5 DTE puts today against SQQQ at 62 while avoiding assignment on all the SQQQ covered calls I wrote yesterday at 65, milking the high volatility as best I've ever done. These were limited bets, but it's fun to have one's entire portfolio go +1.2% on a day the Nasdaq lost 3%. This one day performance gap translates to a year of retirement someday per the 4% rule!

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The unpredictability and volatility is a reminder we should be thinking about long-range trends, not day trades, and focusing very hard on whether we've turned a corner. I'm trying to be on the right side of history, not win a few hundred dollars in a zero-sum game.

Inflation Since June = Either 2% or 6% Annualized
CPI has adopted a new and only slightly positive trendline since June. If we look at the CPI as an index since June, and tell FRED to set June 1, 2022 as the index date with a value of 100, then CPI is now, three months later, 100.5. In other words, since June, CPI has been on a 3-month course that would be roughly (0.5*4=) 2% annualized inflation. This is why the pundits are screaming about how the FOMC has done enough and needs to quit.

Core CPI since June becomes 101.5, which would be ~6% annualized. Note how Core CPI is rising much more quickly than CPI, due to the fall in energy and food commodity prices over the past 3 months. This is why the Fed's focus is shifting to Core CPI; they don't want to declare victory over inflation just because commodities corrected. Arguably the Ukraine war set off a commodities bubble that is bursting, and this temporary effect has little to do with monetary policy, velocity, or supply. PPI has experienced slight deflation over the past 3 months, and is now at 99.8.



Falling commodities prices will eventually catch up with CPI, and the unemployment rate can only go up from here. Thus CPI will probably continue to taper down as the comparison point from 12 months ago goes higher and higher and prices for things stay about the same.

Future Rate Hikes
If nothing breaks(see my other thread for that discussion) I still think we're looking at 0.75% hikes in both November and December. That puts the FFR at 4.75% at the end of the year, in line with futures market predictions. Beyond December the crystal ball gets hazy. The FedWatch tool says market participants are expecting a 0.25% hike in February and maybe March. That would put the FFR upper bound at either 5% or 5.25%. These numbers represent the highest the market thinks we're going to go, and by that time I think we're likely to see inversion of the entire yield curve below 10 year durations.
https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

Taylor Rule Is Looking Good
I've said before that Taylor Rule guidance probably applies here, and the latest inflation numbers make me more confident about that statement. The rate hikes we've had so far may have slowed the pace of inflation slightly, but they appear to be insufficient, unless we want to theorize about long lag times.

Rates need to go above inflation in order to slow down monetary velocity and inhibit people from treating cash like a hot potato. People and institutions will continue to unload cash when the cost of holding it is greater than the interest rate they can earn. They will continue to borrow at less than the rate of inflation too.

According to this perspective, for the Fed to engineer a soft landing, they will have to gently intersect the FFR with the rate of inflation (we should use Core CPI as our inflation metric here, because of recent commodities volatility). Thus the current target for the FFR's terminal rate should be about 6%. However, there are a lot of moving parts:

• Core CPI is likely to be different next spring than it is now. What if, by then, 5% is the intercept point? A lower Core CPI by spring scenario makes sense if you think a slight effect from the most recent rate hikes will just start to be felt by then.
• We know monetary policy works with a lag, but how much? I think about 2 months is the theoretical minimum here, because that's the shortest lag between rate decisions and the reporting of CPI numbers that fully reflect any change after those decisions. The theoretical maximum may be a year or more. This means the FOMC might raise rates in February, only to discover in March that February's inflation rate was already lower than the FFR. It also means the FOMC might raise the FFR above the rate of inflation, and not see results for the next several meetings, which could cause them to enact more rate hikes and overshoot during the lag time.
• The Fed is now looking at shorter-duration treasuries for longer-duration treasuries, presumably in order to reduce inversion of the yield curve, enhance the consumption-reducing effects of rate hikes, relieve pressure on financial institutions, and inject liquidity into the narrowing treasury market. This is what the UK was just forced to do, and it is reminiscent of "Operation Twist" but in the opposite direction we saw in 2011.
  https://www.marketwatch.com/story/this-is-not-qe-or-qt-this-is-none-of-those-why-the-u-s-treasury-is-exploring-debt-buybacks-11665775104?mod=home-page
  https://www.investopedia.com/terms/o/operation-twist.asp
• If "something breaks" such as the repo or treasury markets freezing up, that might lead to an immediate six-month pause in the rate hikes and/or QT.
• Stocks are discounted based on the 10y treasury yield more so than the FFR. But the 10y treasury yield might be less than the FFR at its peak. The FFR-10y gap was ~0.75% just prior to the GFC, for example. Thus we cannot just say if FFR=6%, then 10y yield=7%, then stock earnings yield =8%. For all we know it may be more like FFR=6%, 10y=5.5%, and stock earnings yield=5% if we are in an earnings recession and markets expect rate cuts plus earnings growth.

When To Go Long?
So to summarize, I think the buy signal is when the FFR intersects with or surpasses Core CPI. At that point, we know inflation is going down. The Fed will either take a pause at this point, or something will have broken, meaning there will be no need to account for future rate hikes when discounting stocks, and the 10y yield is likely as high as it's going to go. My current prediction is that this intersection will occur in March at somewhere between 5% and 5.5% for both the FFR and Core CPI ***IF*** a crisis does not break out before then.

For stocks, this means we should discount future earnings at about a 5% 10y treasury yield (+/-0.5%), plus a solid risk premium of 1.5% to 2%. This puts our expected earnings yield at 6.5% to 7%. That translates into a forward PE ratio of 14-15, which is the same target I've been looking at for months. We are currently at a forward PE of 15.5 for the S&P500, and strategically it might be wise to go long at this point rather than accepting the risk of being left behind because you tried to catch the absolute bottom. 
https://www.yardeni.com/pub/stockmktperatio.pdf

However, if you strongly believe that a recession is coming, as I do, any forward PE estimate looks a bit optimistic. We're already 5 months into a trend of sharply falling earnings, according to the estimated monthly earnings table on multpl.com. Who predicted that?
https://www.multpl.com/s-p-500-pe-ratio

If we calculate a PE for the S&P500 based on the 12 months of earnings prior to the last 5 months to represent the stock market's potential if all the problems went away, that PE ratio would be about 12! I'm not saying we can go back to the low rates / low inflation world that created those earnings, but I am saying stocks and expectations have fallen a long way, and may have priced in both a mild recession and a 5% treasury yield.

I want to swing for the fences and wait to go long when there's blood in the streets, financial institutions and nations defaulting, unemployment going up, 100% doom headlines, people jumping from skyscrapers, etc. However there's also a serious risk of being left behind, as I was in 2018 and 2020. Therefore I might pick up some long-duration, relatively high gamma OTM calls if we get a day of low enough volatility. If the market stays down amid a nasty recession, I'll lose the option premium but retain the opportunity to deploy most of my assets in the future at bargain bin prices. If markets go up, I'll sell the options for the difference (losing the time value) and deploy my remaining assets plus profits from the calls, mitigating most, all, or more than the damage from being left in the dust.

I also might fill my fixed income allocation now with some attractive IG bonds and preferreds yielding 6-8%. If rates don't have to go much higher than what is currently priced in before they intersect with Core CPI, then maybe these yields are close to as good as it will get. I think it makes sense to increase one's bond allocation now that interest rates are back in the range where the 60/40 portfolio used to be considered ideal. If things got bad enough, like SHTF 2008-2009 bad, then I could imagine myself doing 20/80 call options or futures / bonds and seeing how I look a year later.

[MustacheAndaHalf]

But let's take an example, and track SPY (S&P 500 ETF) to see what happens.  Oct 12 closing prices:

VIX $33.57
SPY $356.56/sh
UPRO $27.97/sh
SPY call $240 strike expiring 2022-10-31 : $119.97/sh

After a couple dramatic days, taking another look:

VIX $32.02 : -4.6%
SPY $357.63 : +0.3%
UPRO $28.08 : +0.4%
SPY@240 call $118.35 : -1.4%

There's several observations about UPRO from looking at open/close data.
(1) moves outside trading hours do impact UPRO.  If UPRO only moved during the trading days of Oct 13 & 14, its performance would be +4.24%
(2) applying 3x moves to SPY gives -0.2% performance, showing volatility drag.
(3) UPRO gained +0.4% instead of losing -0.2% because it is not purely 3x ... during trading on Oct 13, it should have moved +14.4% but instead gained +15.04%, beating 3x SPY by a +0.64% gain.

The call option was about 2.5 weeks from expiration, but even so did not trade in the last 30 min on Friday.  It might have been better if I tracked the bid-ask spread at both times, but ultimately 3x calls are thinly traded and harder to evaluate.  The option went through 10% of its expiration (or 15% of its trading days, ignoring weekends).  But the rough data shows a drop from 0.956% to 0.201% in time value, suggesting volatility might have been a bigger factor.  But that is rough data, which needs more careful measurement to confirm.

But the overall conclusions are interesting even after just 2 dramatic days:
(1) UPRO volatility drag is mitigated by something, but still significant
(2) call options can fall in value when the underlying (SPY) goes up

[ChpBstrd]

Interesting analysis @MustacheAndaHalf but as you point out when we’re talking about fractions of a percentage we’re talking about pennies on the price of contracts that might go hours between trades. Longer term info would be needed, but then of course you could also just chart the 3X funds vs indices and see how that turned out across different timeframes.

Rather than ETFs tracking an index, leveraged funds should probably be thought of like we think about actively managed funds. That is what they’re doing in a formulaic way - trading futures, options, and swaps on behalf of the people who bought the fund.

I would be interested to know if the long vs short 3X funds tracked their indices better or worse as volatility went up or down. My understanding is that volatility drag would drag down both.

[MustacheAndaHalf]

Rather than ETFs tracking an index, leveraged funds should probably be thought of like we think about actively managed funds. That is what they’re doing in a formulaic way - trading futures, options, and swaps on behalf of the people who bought the fund.

To clarify, 3x ETFs only uses swaps.  You can visit the ProShares website for UPRO and view all their holdings, and you'll see swaps from various banks.  I don't recall seeing futures contracts or options.

I would be interested to know if the long vs short 3X funds tracked their indices better or worse as volatility went up or down. My understanding is that volatility drag would drag down both.

The best approach I've seen for that is rather simple: look at QQQ or SPY, and trace it back to the last time it was at the exact same price.  Then you compare prices of SQQQ / TQQQ or UPRO / SPXS for the same dates.  That shows you how much got lost to volatility over months... I seem to recall it being 20%/year underperformance when I looked last time.  It's more significant than the expense ratio.

I'm thinking of switching back to unleveraged ETFs, like SPY and QQQ.  No volatility drag, and it locks in my earlier gains.  I can ignore my portfolio for awhile.

Another possibility is to buy call options with the lowest strike price you can find.  Those will have the smallest time value, often near half the current price.  So if SPY is $360/sh, the call option with a $180 strike might offer 2x returns on moey invested with the lowest time value.  I should look into those at some point.

[EscapeVelocity2020]

I wonder how you traders are doing this week?  These +/- 2% moves in the index back to back are wild!  And yet the VIX is down ~4% today to ~31??!!

[ChpBstrd]

I wonder how you traders are doing this week?  These +/- 2% moves in the index back to back are wild!  And yet the VIX is down ~4% today to ~31??!!

I've been shopping for corporate bonds today, and placing bids on A-BBB issues yielding in the 7+% range, like Viatris, National Health Investors, Omega Health Investors, Energy Transfer Partners, ONEOK, etc. I bought about $55k and will continue to buy for the next couple of weeks I think. I'm eventually heading toward an AA of at least 50% long-duration bonds.

These long-duration bonds on profitable companies will survive a recession in 2023 and look good on the other side, all while spewing out interest that I'll plow back into stocks. Long-duration interest rates might not be at their peaks, but these purchases will help hedge my risk of missing the peak. Bonds might also go back up faster than stocks if rates are quickly cut but we have a drawn-out, low-growth recovery like 2009-13.

My base case scenario is for a recession sometime in 2023, accompanied by falling inflation and rate cuts late in the year. Today's corporate bond yields are propped up by treasuries (they must have a risk premium over treasuries after all) and when that support shrinks is expected to shrink, so will corporate bond yields.

My market-short exposures obviously got hit hard by today's good bank earnings and the UK's tax plan reversal. We'll see what tomorrow brings while my short calls decay.

I think good bank earnings in this context reflect more about decisions made - or not made - for loss provisions and hedging. In recessions, banks always act surprised by their upticks in defaults. Maybe the market will grow worried about that tomorrow - who knows? All I'm saying is that anyone plowing into financials today because BAC beat on earnings should maybe consider why NLY yields 21%, and how that reason could also affect the broader financial sector!

In my bond shopping I passed up numerous brand-name BDC's and investment banks because I think it's too early. They will be better buys in a panic, if that panic ever comes. Their bad debts will look like a bottomless pit of liabilities in a true bottom. Remember the old-fashioned theory of sector rotation:

[BicycleB]

I wonder how you traders are doing this week?  These +/- 2% moves in the index back to back are wild!  And yet the VIX is down ~4% today to ~31??!!

It feels odd to think of myself as a trader, but I guess the shoe fits now.

Last week, entered a bullish allocation with expected* variance and direction in the same ballpark as S&P 500. I've been getting expected direction and slightly more variance, so today's upward spike was lovely. Now slightly above the "peak" value that I'm aware of from last week.

For the year, investments as a whole down roughly 7% nominal.

*vaguely, foolishly imagined

***
@ChpBstrd, thanks for the sector rotation chart. Very nice summary!

[ChpBstrd]

The Taylor Rule Is The Paradigm
I've concluded the best way to conceptualize inflation is with the Taylor Rule: Inflation will be pushed down when the Federal Funds Rate (currently 3.25%) exceeds Core CPI (currently 6.66% YoY, or ~4.5% if annualized over the past 4 months). The Federal Reserve describes on their website how the Taylor Rule and its derivatives are guiding principles behind their actions. The Federal Reserve's endorsement means if we decide the Taylor Rule is most consistent with the evidence seen so far - as I have done- we can use the same paradigm to predict the actions of the FOMC.
https://www.federalreserve.gov/monetarypolicy/principles-for-the-conduct-of-monetary-policy.htm

Predicted FOMC Actions
The FedWatch tool indicates market expectations for us to end the year at 4.75%, and for rates to rise to a peak of about 5% or maybe 5.25% between March and May (recall that I predicted 0.75% rate hikes at each meeting for the rest of 2022 several months ago, against what the FedWatch tool was showing). I think it's likely the FFR and Core CPI intersect this spring.
https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

This intersection point will be a rational place for the FOMC to take a break and see how things go for a couple of months. By then I expect there to be lots of recession signals flashing, such as the NFCI, initial claims, a 1mo/10y yield curve inversion, producer and consumer surveys, manufacturing reports, and all the other things we've looked at in this thread.

The FFR futures market also sees us ending 2023 right back where we started - at 4.75%. This implies a 0.25% or 0.5% rate cut next fall, in response to recessionary conditions. The market is weakly predicting this outcome despite clear and direct statements by multiple Fed members that the market should not expect any rate cuts in 2023. FOMC members are very aware of the mistakes made in the 1970s, when rates were cut for each wave of recession, and inflation came bounding back as soon as each recession ended. They want to be less reactive, and to fight the long term trend, not the short term noise. They want high inflation to be dead for sure.

There is a chance the FOMC takes another lesson from the 70's-80's and the Taylor Rule: that the FFR needs to exceed CPI by a couple of points in order to firmly squash inflation expectations. However, I don't see a lot of appetite to play the next Paul Volker.

The FOMC's tentative plan is to see if matching Core CPI is sufficient to keep inflation down, and then to keep rates moderately high (i.e. 5%) for a couple of years after inflation has fallen below the FFR, no matter if a recession comes or not. This is a compromise position, with an outcome between the disasters of the 1970s and the risks of not cutting rates during a recession. A lack of rate cuts could make the recession long and severe. Of course, plans change, but that's the course the FOMC is on now.

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Why TF Did You Buy Bonds?
Given this perspective, it may seem surprising that I decided to plow 10% of my portfolio into corporate bonds now, rather than continuing to wait. How can I simultaneously see a Taylor Rule outcome, and also go bullish into anything? Am I fighting the Fed?

Markets predict at least 175 basis points - maybe 200 - of additional rate hikes ahead of us. There could be even more rate hikes if the FOMC decides to pull a Volker and make the FFR exceed Core CPI. Plus, it seems likely a recession will hit in 2023 and then the FOMC will refuse to immediately cut rates like they've done in every modern recession before. This means the next recession could last well over a year, and be more severe than anyone expects (Powell called this "pain"). Won't the interest rates on my bonds be higher, or their ratings lower, in 6-12 months? Isn't the peak of the downgrade and default cycle still ahead of us?

I'm not confident in my decision to start deploying cash, but I have my reasons:

• I think long-duration treasuries will peak at a lower level than the FFR. We will soon see an inversion between the 10y treasury yield and the Federal Funds Rate. Thus, if the FFR hits 5.25% this spring, then maybe the 10y yield hits 4.5%. That's only 0.5% higher than the 10-year treasury is today. Thus, the outcomes of a 5% or 5.25% FFR are mostly priced into longer-duration bonds. We saw inversions in the 0.5%-0.75% range like this in 2000, and again in 2006-2007. The FFR/10y inversions were even larger in the 70's. Thus, sitting in cash waiting for the day of 6-7% long-duration treasury bonds is too risky.
• The risk premium of BBB bonds over treasuries is now over 2%, which is historically reasonable.
  https://ycharts.com/indicators/us_corporate_bbb_bond_risk_premium
  https://fred.stlouisfed.org/series/BAMLC0A4CBBB
• The spread between corporate bonds and treasuries can go much higher during a full-fledged market panic, as shown in the charts. But the benefits of waiting to buy in a hypothetical spread-spike have to be weighed against the cost of missing out on 6-7% interest per year and the risk of failing to buy or being unable to buy desirable corporate bonds due to illiquidity. E.g. a 10 year corporate bond yielding 6% will lose 6.6% of its value if interest rates are 1% higher a year later. That means you almost break even due to the interest payments, despite missing the bottom. Phrased another way, this scenario is the cost of being wrong about the Fed taking a break at the likely intersection point between the FFR and Core CPI, and continuing to hike rates an extra 1% anyway. Note that I was dead set against bonds 1-5 years ago because the interest payments were insufficient to offset duration risk, but at today's yields the risk is much lower.
  https://www.thecalculator.co/finance/Bond-Price-Calculator-606.html
• Of course the optimal thing to do in the above "extra 1% in one year" scenario would be to sit in 1 year treasuries earning 4.5% while waiting for rates to rise, but that's a gamble in its own way. E.g. if something caused rate expectations to fall, the Fed slowed their rate hikes earlier than expected, and/or if other market participants rushed into bonds, you'd have missed the chance to lock in relatively high yields that could have coasted you through early retirement or the chance to capture gains from the duration effect. Maybe a spike in treasury-BBB spreads is likely, but there's a real risk of being late for the gravy train too. I will probably balance my short-duration and long-duration bond allocation in some way to be prepared to deploy more cash in the event investments keep getting cheaper, but also mitigate the chance that we're already near the top in rates, and at a historical buying / retiring opportunity. This is essentially the same market timing debate about buying now versus waiting for lower prices, and the best solution is to DCA because that approach eliminates most bad outcomes! That's what I'm doing as the recession approaches.
• The next chapter in this story almost certainly involves a recession, falling inflation, and falling stock valuations. Usually I would say the story includes rate cuts, but this time might be different because of the FOMC's plan to treat inflation as a long-term chronic condition rather than repeating the mistakes of the 70's, with its zig-zagging monetary policy. The Fed may refuse to cut rates as quickly as they've done in the past, due to fears about inflation coming back. Of course, even the legendary FOMC under Paul Volker quickly cut rates in the face of severe recession, so resisting this kind of economic and political pressure would be a first for the Fed. Nonetheless, if the economy is NOT bailed out of the next recession, it is likely the next recession will be longer and more severe than typical. Think 10% unemployment and over a year in duration! Probably we never see ZIRP again, but I think the Fed will slowly lower the FFR to somewhere between the terminal level of 5% and their 2% long-term inflation target. The FFR futures market is no longer unreasonable in its expectations for a Dec. 2023 FFR of 4.75%, and assigning odds to a small rate cut in late 2023. The conversation will eventually shift to when the FOMC will cut rates and by how much. At that time I think it'll be nice to hold the bonds I bought. If the Feds say damn the torpedoes, we're not cutting rates, then IG bonds will not be the worst place to be because they're already priced for the most likely peak rate path.
• In my personal investing history, the number of times I got ambushed by a recession is smaller than the number of times I missed a bottom and got left behind by a market rebound. Similarly, my losses due to recessions are probably smaller than my opportunity losses due to waiting a little bit long to reallocate aggressively amid bear markets and corrections. This history suggests I should aim for a low point to reallocate, but not wait for things to get as despairing as the bottom was in 2002 or 2009 for example. At such points, it always looks like even worse is just around the corner, so I tend to delay, disbelieve the rally, and catch up later. There is a certain logic in locking in stock-like returns while they're available now rather than playing the timing game.
• If history is any guide, right after a recession is a great time to pick up growth and financial stocks, because growth gets heavily discounted and banks' liabilities look shaky. Suppose a year or two from now, I'm watching the Fed cut rates amid high unemployment, lingering pessimism, an S&P500 priced with a multiple in the low to mid teens compared to pre-recession earnings, and a collapsing spread between corporate bonds and treasuries. That will be a great time to pivot from IG corporate bonds into funds like VGT, XLF, and VBK. This game plan backtests well for all recessions in recent decades, even if one's timing isn't perfect. It also relies upon real-time observable factors like a declared recession, rate cuts, and low stock valuations compared to pre-recession levels. So it's not a bad idea to position oneself now in a way that one can be prepared to make such a pivot in the future. And if that scenario doesn't play out? If there's no recession and everything rebounds immediately, I won't mind holding IG bonds at much higher yields than my future withdraw rate.

How I Could Be Wrong
The obvious downside to this forecast and investing plan is if Core CPI takes on a life of its own and keeps growing. The Taylor Rule suggests we are STILL in stimulative territory, because the FFR is currently about 3% below inflation! Plus OPEC is cutting output. Plus the US consumer still appears to be in good shape, with a near-record low debt service to income ratio, and is no doubt planning a BIG Christmas gift-buying extravaganza because so many families were unable to get together during the 2020 and 2021 holidays. Plus there are the risks of a railway strike, further logistics problems, and further lockdowns in China. Heard of the BQ variant yet? You will.

Basically there are lots of reasons for inflation to keep rising. If Core CPI rises to 7% or 8% by the end of this year, the FFR futures market will be talking about a much higher terminal rate and I'll regret my bonds. But I'll be glad I didn't invest in stocks, FWIW!

Can We Just Retire On Bonds?
A portfolio heavy on fixed income is highly vulnerable to inflation because the yields on corporate bonds are nominal and you get no additional return as prices adjust. Each coupon, and your eventual return of principal, is worth less and less as it is eroded by inflation. There is a temptation to say "Look, if you allocate 100% to bonds yielding 7%, and retire with a 4% WR, then you can reinvest the remaining 3% of your yield each year and thereby keep the value of the portfolio constant in real terms so long as long-term inflation does not exceed 3%. That's about the long-term average US inflation rate between 1913 and 2020. Even if inflation averages, say, 5-8% like in the 70's and 80's, then your real portfolio depletion rate will be roughly that number minus 3%, which is probably a better result than stocks would deliver under the same conditions if you are buying at today's CAPE of 27. If, OTOH, the US experiences a Japanification outcome, where inflation stays near zero for a decade and refused to budge, your strategy would look genius."

If we have a severe recession, and the FOMC refuses to cut rates by more than a token amount (like 0.5%), then it is possible we get massive demand destruction, bankruptcy or zombification of loan-making financial institutions that facilitate monetary velocity and M3 growth, and very low inflation for a decade, like after 2008 in the U.S. and like after 1990 in Japan. The signals for this scenario emerging will be visible in real-time, so a decision can be made in the future about whether to drop one's high-yielding IG bonds for stocks, or to hold the bonds long-term.

In the short run, it is tempting to just load one's portfolio with 7% yielding bonds and take a couple of years off work with a 6-7% WR. If in a couple of years, rates and spreads have collapsed, then the appreciation of your bonds will likely have almost funded a couple years of sabbatical all by themselves, and you're back where you started in real terms after enjoying 2 years of freedom. If in a couple of years, inflation is still raging, then it's likely that the Fed goofed up and left rates too low for too long (reducing losses on the resale price of your bond) and stocks will be at compelling values with PE ratios in the low teens. This would be a tempting time to go all in on stocks and BaristaFIRE for whatever the dividends don't cover. There are a lot of possibilities for win-wins like this now that we have actual yields to work with!

[ChpBstrd]

The bonds I bought last week are down between 2-4% from where I bought them, but I only deployed a small fraction of my capital and plan to sorta-kinda DCA into corporate bonds over the next 8-12 months. Interest rates have been on a tear this month, especially long-duration treasuries. Ten-year treasury yields are up 58 basis points since three weeks ago, and 30-year treasuries are up 67 basis points. The change in treasury rates since just a week ago accounts for my losses, and demonstrates the knife-catching nature of deploying assets in the midst of economic trouble.

https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value_month=202210

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The 3 month / 10 year yield curve briefly inverted on 10/18 and then reversed course the next day. It is likely to invert again. This particular spread is know for its high accuracy as a recession predictor, and for giving advance warnings of between 5 months and a couple of years.
https://fred.stlouisfed.org/series/T10Y3M
https://mishtalk.com/economics/on-average-how-long-from-inversion-to-recession

I looked at the history of the FFR for clues about which timeframes seem most likely if we are making a one-year trip from 0.25% to 5%. The best precedent for a rate hiking series of that magnitude and speed was the campaign that started in March 1972, saw a 3m/10y inversion in June of '73, and a recession start in November of '73. Of course, that rate hiking series was about 750 basis points before the recession even started, AND those hikes started a year and eight months prior to the recession. However, the rate hiking campaign reached today's predicted 475 basis points of rate hikes by June of '73, the same month as the 3m/10y inversion, and 5 months prior to 16-month recession.

The futures markets and I suspect we'll reach 475 basis points of hikes by June of '23. Everyone is expecting a recession to start in the first or second quarter of 2023, but a review of history suggests it takes a long time to slow the US economy to a stop. In '73 the recession didn't start until November, and that was after ~750 basis points of rate hikes! When will our recession start if the Fed pauses the rate hikes next summer instead of going full-speed-ahead for the rest of the year as they did in '73? Maybe later than November!

Of course, inflation gets a vote too. In '73, inflation kept piling higher and higher, despite all the rate hikes the Fed could throw at it, and despite the FFR usually being higher than CPI.


We cannot rule out such a possibility, even with the near-zero July monthly CPI reading. Monthly CPI hit zero in Feb '71, Mar '72, and Jul '73, and that's what one of the worst outbreaks of persistent inflation looks like! This is why all the Fed's critics who are saying "look at the monthly data" are wrong. These data are too noisy to detect trends on a month-to-month basis.

------------------------

Money supply metrics were released today and they are a big deal! M2 has been roughly flat since March, but in September M2 actually decreased significantly for the first time... ever as far as I can tell! 


The trend is clearly being driven by a decline in M1, and probably reflects quantitative tightening.


What I'm really looking forward to is monetary velocity, which will be released Thursday. If both money supply and velocity start falling together, that's a good sign of recession. A falling velocity of money also has had a way of preceding recessions after 1991.
https://fred.stlouisfed.org/series/M2V

However the GDPNow tool is "nowcasting" GDP growth at 2.9%, well outside the range of professional forecasts. There's something in the data that suggests economic activity is increasing, such as falling initial claims, high orders for durable goods, or still-rising inventories.
https://www.atlantafed.org/cqer/research/gdpnow
https://fred.stlouisfed.org/series/ICSA
https://fred.stlouisfed.org/series/DGORDER
https://fred.stlouisfed.org/series/BUSINV

[BicycleB]

^Really liking this post, @ChpBstrd!

Re 1972-73, and the recession starting Nov '73, the oil crisis due to OPEC embargo began Oct '73. I and I thought many others have assumed that the embargo shocked America into recession. Knowing the long campaign of rate hikes prior to that makes me view the situation as more complex. Below are brief reading results and questions.

Summary of timeline and events:
https://en.wikipedia.org/wiki/1973_oil_crisis

Perspective per Michael Corbett, Federal Reserve Bank of Boston, contains comments on monetary context along with Federal Reserve's thinking:*
https://www.federalreservehistory.org/essays/oil-shock-of-1973-74

Was the oil embargo a smaller factor than people like me believed? Or would the recession have begun even later without it? If the latter, perhaps our own recession will take even longer than the example suggests.

I guess this implies support for the idea that we could have a long time before the full bite of recession appears. If so, would stocks have time for a large runup, then plunge as real recession manifests? Or is that too simple a model, given that stocks usually are a leading indicator compared to recessions?

Maybe stocks will go up for a time, then down, then be rebounding by the time the real recession arrives. I guess the linkage between stock prices and recession timing is loose enough to make predictions difficult.

*The article notes that the Fed underestimated its influence on inflation during the 1970s, but now it appears to me that the Fed's influence is widely recognized. Are analysts now overestimating the Fed's power? How would we recognize this?

[blue_green_sparks]

Gold (and Crypto?) are pretty cheap right now.....it will be interesting to see how they do if we do indeed land in a deep recession next year. 

[ChpBstrd]

@BicycleB yea there are some creepy similarities between the 1973-74 era and the 2022-2023 era that go beyond interest rates:

 -The U.S. had just given up after losing a very long and expensive guerilla war in Asia, against an impoverished and illiterate enemy.
 -The U.S. provides material support to a young democracy being attacked by neighbors, between about 30 and 45 degrees eastern longitude, causing shortages and disruptions in the flow of energy.
 -Food prices go up rapidly due to supply-side constraints (drought in '73, war in '22).
 -All this occurs in an environment of limited supply-side spare capacity as both A. Burns and J. Powell noted.
 -The U.S. dollar had just been "devalued" in a sense, either by dropping the gold standard or by pandemic relief helicopter money.
 -People are still buying massive, tacky land yachts with V8 engines, and yet still complaining about the price of gas.
 -Productivity is in decline again: https://fred.stlouisfed.org/series/OPHNFB
 -The labor participation rate is again in the low-60's: https://fred.stlouisfed.org/series/CIVPART
 -All this occurs in an era of cultural upheaval and backlash to change, and about 25 years after the introduction of new means of mass communication (TV and social media).

I guess this implies support for the idea that we could have a long time before the full bite of recession appears. If so, would stocks have time for a large runup, then plunge as real recession manifests? Or is that too simple a model, given that stocks usually are a leading indicator compared to recessions?

Maybe stocks will go up for a time, then down, then be rebounding by the time the real recession arrives. I guess the linkage between stock prices and recession timing is loose enough to make predictions difficult.

Correct. Stocks typically rally after a yield curve inversion, prior to the recession, and these rallies can be huge.
https://cfifinancial.com/blog/stock-market-performance-after-yield-curve-inversion

The average run-up from inversion to "the top" is almost 29%! This really underlines the dilemma for bearish investors. Yes, a recession is coming eventually, but until that happens the economy is typically feeding on itself in an upward spiral of overheating. Eventually higher interest rates come in and extinguish the blaze, but the economy can always get a lot hotter despite raising rates and falling consumer confidence. Bears can both be right about the macro picture, and lose their shirts as the last of the dumb money plows into bear-market rallies. This is part of why I'm so focused on theoretically figuring out if we are still in stimulative policy territory, because the FFR<Core CPI.

If you want to know why I'm not all-in on bearish ETFs or options spreads, this is why. It should be much easier to wait for the recession to definitely arrive, and then make up for lost time by going long. However, there's a bit of impatience if I must wait over a year for that recession to even start! Perhaps I'm displaying that sort of impatience by DCA'ing into corporate bonds while rates are still rising, and while the peak of this rate cycle is still obscured by clouds?

*The article notes that the Fed underestimated its influence on inflation during the 1970s, but now it appears to me that the Fed's influence is widely recognized. Are analysts now overestimating the Fed's power? How would we recognize this?

Good point. After the last 20 years it is a widespread cultural assumption that the Fed is almighty. People actually resent the Fed because they perceive the Fed's activities as controlling or limiting their personal economic outcomes. However, as one of my favorite YouTube economists Dr. Joeri Schasfoort noted, the actual record of the Fed is quite poor. Their inflation expectations and forward guidance about their own future behavior have been inconsistent. They even lack a working theory of inflation. The tools they use, like balance sheet adjustments and interest rates, are supposed to indirectly affect inflation by indirectly affecting demand and the rate at which private banks create money supply (and remember, private banks, not the Fed, create most money supply!).

https://www.youtube.com/watch?v=tkDVeaTl61o
https://www.youtube.com/watch?v=prF1aUeTzzM&t=10s

If our culture has misplaced confidence in the Federal Reserve, then maybe a lot of the market's assumptions are also wrong. The futures market's estimates of a 5% peak in the FFR, economists' forecasts of falling inflation in 2023, and the low expected inflation rates reflected in 2 and 5 year spreads reflect a belief that relatively minor tweaks by the almighty Federal Reserve can reduce a CPI that is over 8%. Just because they're almighty - got it!?

If that proves untrue, 2023 could look a lot more like 1974 in terms of the size of rate hikes required to bring down inflation and the stock/bond losses! Maybe we're still in denial, clinging to slogans and memes instead of facing the brutal truth?

If we assign any significant probability to an outcome like an 8-10% FFR, it's maybe another reason to hang out in short-term treasuries taking a wait-and-see approach rather than DCAing into financial assets right now, because '73 and '74 were both double-digit down years - and starting from much lower stock valuations than we have even today! We need to really examine whether we have good reasons to hold the assumption of an all-powerful Fed. Yes, they pulled the US out of the GFC and COVID crises, but how's their record on inflation? Can they predict it? Can they predict their own responses to it? Do they have a working theory of inflation? All these answers are no.

The Fed looks more like a doctor whose only skill is the administration of adrenaline to dying patients. They're good at fixing that one type of problem.

---------------------

Today's release of the National Financial Conditions Index - one of my favorite recession predictors - was less bad than the last couple of weeks. Yet conditions are still tight, and we remain a hair away from hitting the zero bound which has been a decent predictor of recessions in the recent past.
https://fred.stlouisfed.org/series/NFCI

[PDXTabs]

The consumer still seems strong.

American Airlines Reports Third-Quarter 2022 Financial Results "Record quarterly revenue of $13.5 billion, which represents a 13% increase over the same period in 2019, despite flying 9.6% less capacity."

American Express Q3 results "We continued to see high levels of customer engagement, acquisitions and loyalty across our premium Card Member base, with overall spending up 21 percent (24 percent on an FX-adjusted basis), driven by growth in both Goods & Services and Travel &Entertainment spending. The demand for travel has exceeded our expectations throughout the year, with spending on T&E increasing 57 percent from a year earlier and T&E spending volumes in our international markets surpassing pre-pandemic levels for the first time this quarter, both on an FX-adjusted basis."

I'm one of those consumers that spent most of September traveling and I have another flight booked next month.

[Mr. Green]

The desire for revenge travel and spending coming out of the pandemic has been grossly underestimated.

[ChpBstrd]

Today is a quarterly holiday for econ nerds: The release of monetary velocity statistics! Recall that an increase in the velocity of money is the definition of inflation from a Keynesian perspective. The more frequently people spend and earn money, the more prices are pressured upward. I interpret these results alongside the savings rate to get a perspective on what consumers are doing.

The velocity of M1 (cash, bank accounts, money market accounts) has been flat for about the past 8 quarters. This flatness is in contrast to a declining velocity of M1 during the disinflationary twenty-teens.


The velocity of M2 (M1 plus time deposits other than retirement accounts) has been on a fast-rising trend in 2022. Again, this is in contrast to a declining velocity of M2 during the disinflationary twenty-teens.


Let's unpack the difference between a flat M1 and a rising M2. I'll need help with this interpretation, and your results may differ, but here's what I think. I'm very interested in alternative interpretations.

Explaining The Big Drop In Monetary Velocity
First, the elephant in the room is a dramatic drop in the velocity of the average dollar that occurred in Q2 of 2020. Recall that this dip coincides with, and is a mirror image of, a dramatic increase in the supply of money which occurred at that same time due to a series of bills including the $2.2T CARES act, at a time of a $3T national deficit.



M1 went from $4.7T to over $16T overnight. M2 grew a bit slower, but still dramatically, from $15.3T pre-pandemic to a peak of $22T in April 2022. However all these new dollars did not immediately start trading for goods and labor in the economy at the same speed as pre-pandemic dollars had traded. People's wages and purchasing needs were close to the same in 2021 as they were in 2019. So essentially a lot of these dollars sat on the sidelines, in the sort of short-term demand accounts measured by M1 or M2, or by reducing debts. The stimulus plans were designed to bail the U.S. out of a deflationary second Great Depression, but (because of the stimulus plans) no such depression materialized. Not even a prolonged recession!

All the new dollars sitting idle in bank accounts with a velocity near zero pulled down the average velocity for all the dollars in the system. Thus a 43.8% increase in M2 was associated with a 21.9% decrease in the velocity of M2 across the same timeframe (Q1 2020 - Q1 2022).

So I think the following things occurred:

• People and corporations paid down consumer debts and held larger short-duration accounts, unsure of what to do with the windfall. Banks invested the wave of early repayments and deposits in treasuries.
• An increase in banks' demand for treasuries kept their prices low in 2020 through early 2021 despite an exploding supply. This increased treasury trade sidelined much of the new money created in 2020 and 2021. Essentially, the pandemic-era handouts were handed right back to the government in exchange for treasuries, after only one or two transaction cycles through the economy. Stimmie checks probably still exist in the bank accounts of some consumers, and were used by their banks to buy treasuries.
• Meanwhile, QE was injecting more money into the economy, causing a steady rise in M1 and M2.
• Economic activity boomed between 2020 and 2022 due to falling unemployment, which increased the creation of money by private banks through lending.
• As economic uncertainty hit in 2022, money flowed from risk assets not measured by M1 or M2 into short-duration deposits, increasing M2. M1 was unaffected, as the funds went into treasury bills, commercial paper, and money market funds. This occurred as risk asset prices fell. For everyone who used a stimmie check to buy stock in Meta at $345, there was someone who sold Meta at $345 and who may have moved their dollars into safer and more liquid accounts measured by M2 but not M1 - like short-term treasury bills for instance. No new cash, bank account deposits, etc. were created, so M1 was unaffected by this investment flow.
• As interest rates rose in Q2 2022, banks suffered losses on any un-hedged longer-duration treasuries they had purchased a year or two before. Most economists think rising rates discourage financial institutions from lending to the private sector, because they can get fairly high rates from lending to the government and because their cost of capital rises (higher rates required to attract money to the bank). In practice, however, periods of economic uncertainty and rising rates can drive depositors to the safety of bank accounts (M1) and highly liquid safe securities (M2), leaving banks with lots of low-cost assets they can redeploy into higher-yielding treasuries. Despite inverted yield curves, all the bank has to do is pay a lower rate of interest to depositors than they're earning in treasuries. Today your bank can earn over 4% annualized on 3-month treasuries with insignificant duration risk. How much of that is your bank paying you? Bank margins are not necessarily in perfect alignment with interest rates. See: https://www.stlouisfed.org/on-the-economy/2016/may/banks-more-profitable-interest-rates-high-low and https://fred.stlouisfed.org/series/QBPQYNTIY
• As inflationary pressures became a bigger concern in 2021 and 2022, fully-employed consumers started taking advantage of low loan rates - which were kept low by a lack of competition from treasuries yielding <1% in 2021 - and pulled ahead purchases of things such as durable goods, cars, and houses. By pulling ahead their purchases, consumers believed they were avoiding higher prices in the future, and the savings were expected to more than offset the cost of loans. This rush to buy things increased inflation even further, perpetuating the cycle. Because consumers are flush, fully employed, and have a historically low percentage of consumer debt to disposable income, this cycle could have a lot further to go. The co-increasing velocity and level of M2 occurred when consumers liquidated investments not counted in M2, moved the dollars into places counted in M2, and started contributing to velocity by buying things.

The next steps could be:

• A wage-price spiral continues while loans can still be had for less than the rate of inflation. That is, until the FFR hits about 7% or 8%. Until then, employment stays high. M2 and velocity of M2 continue to accelerate upward, as funds once allocated to investments are applied to pulling forward purchases.
• Further price collapses for risk assets: Bitcoin, houses, and tech stocks don't look so awesome in a world where one can earn 6-7% from investment grade stuff! Mortgage rates just hit 7%, which was unthinkable just a few months ago. Home sales in my area have essentially ceased. Why gamble on any of these things when you can get a solid ROI just by buying a new macbook/appliance/bed/car/TV this year instead of next?
• The velocity of M2, which has increased at a slower pace than the 43.8% increase in M2, finally catches up to the supply of money, as more and more dollars are transacted more and more quickly and as the supply of new treasuries dries up due to reduced government spending. If we multiply the 1.14x velocity of M2 in Q1 2022 by 1+0.438 - the increase in supply of money - we obtain what I'll call a "pre-pandemic adjusted velocity of money" around 1.63x. That's 18.2% more exchanges of money per year than there were in Q1 2020. Compare that number with a cumulative CPI increase of 11.44% between 3/20 and 3/22, or a cumulative CPI increase of 14.95% between 3/20 and 9/22, or a cumulative Core CPI increase of 11.89% between 3/20 and 9/22. This may not be a perfect 1:1 comparison - it ignores changes in supply, foreign flows, savings rates, etc. - but I think it demonstrates that we should be mostly past the portion of this inflationary cycle that could be attributed to growth in the money supply. Thus we may be entering the phase where inflation is attributed to a wage/price spiral, or where inflation just collapses to normal under the weigh of higher rates, QT, and recession expectations.
• A speeding economy can cover up things like negative home equity, bank losses on treasuries and bad loans, asset price bubbles popping, energy price hikes, poor risk management by financial institutions, forex and sovereign debt issues, market liquidity issues, and more. Yet if the layoffs come fast after this holiday season, the question of what's the next thing to break could take on added urgency. This description of more and more money flooding into short-term safe deposits, and banks being forced to recycle more and more dollars into treasuries, explains why we may soon see illiquidity in the treasuries markets and various "twist" operations to maintain liquidity across maturities. The Fed knows that volatility alone is sufficient reason for the treasury market to dry up, because these participants, operating on hair-thin margins, need to be assured of proper trade execution.

----------------
The 3 mo / 10 year yield curve has been inverted for the past couple of days, in case there was any doubt about a recession on the way:
https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value_month=202210

Meanwhile GDP grew at an annualized 2.6% in Q3, supporting the observations of @PDXTabs and @Mr. Green.
https://www.marketwatch.com/story/coming-up-third-quarter-gdp-11666872767?mod=home-page

Of course, that probably means now is NOT the time to be spending one's capital on travel, because there are juicy investment yields awaiting those who can stand to hold their cash through this time! Repent and reform @PDXTabs !!!

[Mr. Green]

Interestingly enough, I saw a screenshot the other day of some forum for Airbnb hosts where someone was asking if they were the only one who has seen their reservations fall off a cliff. Apparently this was not the first post by someone asking about it. Could be that the ever increasing prices hosts and hotels were able to get as we came out of the pandemic may have finally crossed the threshold where fear of a coming recession has caused people to hit the brakes hard on overnight stays at such eye watering rates. I think the travel season of 2023 is when all the chickens are coming home to roost.

[ChpBstrd]

Interestingly enough, I saw a screenshot the other day of some forum for Airbnb hosts where someone was asking if they were the only one who has seen their reservations fall off a cliff. Apparently this was not the first post by someone asking about it. Could be that the ever increasing prices hosts and hotels were able to get as we came out of the pandemic may have finally crossed the threshold where fear of a coming recession has caused people to hit the brakes hard on overnight stays at such eye watering rates. I think the travel season of 2023 is when all the chickens are coming home to roost.

This is in contrast with the trend toward travel. I wonder if people's preferences are starting to pivot toward hotels, with their reward programs, lack of fussiness, and cheaper rates. If hosts start selling their vacant and negative cash flowing homes into a recession with 7+% mortgage rates, it could have interesting effects, particularly in vacation destination areas. This industry has never been through a prolonged recession, so I'm sure some hosts are barely cash flow positive, and will be shaken out.

[wageslave23]

Does anyone have a plausible explanation for the recent stock market rally? The August inflation data was horrible, and the market has only rallied since then.  I must be missing something. 

[ChpBstrd]

The PCE measure of inflation was reported on Friday at 8.24% annualized for September.


https://fred.stlouisfed.org/series/PCE#0

On a month-over-month basis, September PCE increased 0.64533% over August. That represents a faster rate of increase than July and August, and would translate to 7.74% if you multiplied it by 12. The FOMC has indicated that they look at PCE very closely when making rate decisions, and this one definitely justifies a 0.75% rate hike on Wednesday. The futures market assigns an 86% probability to this outcome: https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html?redirect=/trading/interest-rates/countdown-to-fomc.html

At this point, it's fair to ask whether the rate hikes and QT performed so far have had any effect at all. How do you interpret this graph?


My narrative is the rate hikes popped the commodities bubble which had accelerated due to pandemic-era shortages, was fueled by the sudden increase in PCE after the March 2021 stimulus package, and peaked soon after Russia's invasion of Ukraine. That drove down PPI in July 2022, and the lower commodities prices even dragged down CPI and PCE. This created the illusion that inflation was on the mend, amid happy headlines about a Ukrainian grain export deal and demand destruction. However, inflation has spread from pandemic shortages and a commodities bubble to a steady monetary or expectations-driven phenomenon, as evidenced by Core CPI continuing to rise against the trend of the other measures.

Now an OPEC output cut is already pushing crude oil back up, Russia is quitting the grain export deal, and a LOT of Americans are going to be burning a lot of vehicle fuel this holiday season, so there's a good chance of a Q4 commodities and inflation re-spike. What I'm seeing is the inflation statistics other than Core CPI being very sensitive to commodities fluctuations, but Core CPI revealing the underlying trend.

So far, the FOMC has not let the commodities fluctuations fool them into declaring inflation dead based on a good month or two of data. A pair of 0.75% hikes in Nov. and Dec. appear likely, because as far as I can tell the needle has barely moved. I mean, inflation would likely have accelerated faster over the past 6 months if we were still at 0.25%, but 3.25% is still stimulative in a world of 7-8% inflation.

The 4.75% rate at the end of December will also still be stimulative, just a bit less so. Maybe instead of stimulating 7-8% inflation it only stimulates 6-7% inflation, but that won't be enough to stop another set of rate hikes, even if the Fed takes a pause for a month or two. We also have to keep in mind that PPI inflation has far-outpaced CPI inflation for the past 21 months. The only reason margins have stayed high - hit records in fact - is because prices are rising faster than wages.
https://apps.bea.gov/iTable/?reqid=19&step=3&isuri=1&1921=survey&1903=239


Stocks (other than tech) had a big October because there was no FOMC meeting and thus no rate hike. Also, polls suggested Republicans will win control of Congress, which will lead to gridlock policy stability, which Wall Street tends to like, despite the heightened risks of national default. I suspect the party could end on Wednesday when Powell and other policy makers come out with Strongly Worded Statements about how inflation remains too high. Friday's PCE data, the velocity of money data, and Core CPI all point to the conclusion the FOMC's actions to date have yet to make a dent, so they'll say something to manage expectations a nudge higher. Perhaps the Feds know inflation will only be beaten when FFR>CoreCPI but they don't want to say so, because that would cause panic.

I maintained only small market exposure this month due to the foreseeable portion of these causes. I think Nov-Dec might also be risky months to go short, because by all indications this will be a blowout holiday shopping season. After Christmas, traders will take another look at their assumptions of 5% peak rates, which will be much closer by then, and they'll think about monetary velocity in the framework of a consumption and travel frenzy.

Futures are still predicting a 5% peak rate but the 5.25% prediction is about to overtake it. There's still a slight dip in the forecasted FFR for November 2023, suggesting that Sept-October 2023 is when the market thinks something will occur to cause a small rate cut. That is a timeframe which makes historical sense in the context of yield curve inversions and the time to the start of the recession.
 
The chart below illustrates the long-run difficulty of predicting a path for stocks over the next two years, and the risks of going short. My read is that perhaps the best outcomes start from a place with lower valuations, like 1978 and 1988.

[dividendman]

Does anyone have a plausible explanation for the recent stock market rally? The August inflation data was horrible, and the market has only rallied since then.  I must be missing something.

What else is there to buy?

Bonds will get whipped some more if rates go up and are yielding less than inflation anyway.
Cash is losing to inflation
Gold is tanking
Commodities are tanking
Real estate is tanking

Stocks... sure, they might go down more, but at least they're mostly in profitable companies with (currently) strong balance sheets and if you hold on should do OK even with inflation etc.

[PDXTabs]

Does anyone have a plausible explanation for the recent stock market rally? The August inflation data was horrible, and the market has only rallied since then.  I must be missing something.

Earnings, as a whole, have come in better than feared. Or at least that's my interpretation.

[wageslave23]

Does anyone have a plausible explanation for the recent stock market rally? The August inflation data was horrible, and the market has only rallied since then.  I must be missing something.

What else is there to buy?

Bonds will get whipped some more if rates go up and are yielding less than inflation anyway.
Cash is losing to inflation
Gold is tanking
Commodities are tanking
Real estate is tanking

Stocks... sure, they might go down more, but at least they're mostly in profitable companies with (currently) strong balance sheets and if you hold on should do OK even with inflation etc.

Losing 8% to inflation is still better than losing 8% to inflation plus capital losses from stocks.  But what do I know, I just don't even see a shred of positive from the last two weeks.

[wageslave23]

Does anyone have a plausible explanation for the recent stock market rally? The August inflation data was horrible, and the market has only rallied since then.  I must be missing something.

Earnings, as a whole, have come in better than feared. Or at least that's my interpretation.

But I think the rally started before earnings were released.

[dividendman]

Does anyone have a plausible explanation for the recent stock market rally? The August inflation data was horrible, and the market has only rallied since then.  I must be missing something.

What else is there to buy?

Bonds will get whipped some more if rates go up and are yielding less than inflation anyway.
Cash is losing to inflation
Gold is tanking
Commodities are tanking
Real estate is tanking

Stocks... sure, they might go down more, but at least they're mostly in profitable companies with (currently) strong balance sheets and if you hold on should do OK even with inflation etc.

Losing 8% to inflation is still better than losing 8% to inflation plus capital losses from stocks.  But what do I know, I just don't even see a shred of positive from the last two weeks.

Yeah, but the difference is the 8% (or whatever) loss to inflation is guaranteed, whereas stocks can go up.

[ChpBstrd]

Does anyone have a plausible explanation for the recent stock market rally? The August inflation data was horrible, and the market has only rallied since then.  I must be missing something.

What else is there to buy?

Bonds will get whipped some more if rates go up and are yielding less than inflation anyway.
Cash is losing to inflation
Gold is tanking
Commodities are tanking
Real estate is tanking

Stocks... sure, they might go down more, but at least they're mostly in profitable companies with (currently) strong balance sheets and if you hold on should do OK even with inflation etc.

Losing 8% to inflation is still better than losing 8% to inflation plus capital losses from stocks.  But what do I know, I just don't even see a shred of positive from the last two weeks.

Yeah, but the difference is the 8% (or whatever) loss to inflation is guaranteed, whereas stocks can go up.

Actually the 8.22% loss to inflation is a sunk cost. That's what happened over the last year. If the history of inflation teaches us anything, it's that the next 12 months could look dramatically different. It could be an environment where the real returns on cash are better than stocks, bonds, RE, gold, commodities, etc. Prices could FALL in a severe recession.

I'm proceeding under the assumption that the Federal Reserve will eventually win its battle against inflation. The remaining questions are about timing, peak rates, and the economic consequences.

Of course, my whole adult life has occurred during a time when the government had a good grip on inflation, so maybe I'm not accounting for changing realities. Yet it's hard to envision a different future than the FOMC continuing to raise rates until we get a string of 4-6 months where Core CPI is at a 2-3% annualized rate OR a financial crisis starts. Those are the signals to continue not fighting the Fed in a different way by purchasing long-duration assets rather than avoiding them.

[ChpBstrd]

Here's a good synopsis of the Fed's approach over the past 3 years, with selected quotes. This context could help us understand Powell's next moves. Given his background as a lawyer and investment banker, I suspect the next move does not involve a mea culpa, or any significant change in process.
https://www.marketwatch.com/story/why-did-inflation-surge-to-a-40-year-high-here-are-4-causes-of-the-worst-monetary-policy-mistake-in-years-11667318263?mod=home-page

For more than a year prior to the pandemic, the Fed had been working on a new policy framework...

With the new playbook, the Fed essentially decided it would not raise interest rates at the first sign of a strong labor market, which had become a cardinal rule after the the bout with high inflation in the 1980s. Instead, the Fed would be more patient before using the blunt tool of raising interest rates to increase borrowing costs for businesses and consumers to tamp down inflation

This upended the Fed’s longstanding reliance on Phillip Curve models that say that tight labor markets and wage pressures are a main driver of inflation.

"The framework document came after 20 years of it being very difficult to get inflation to 2%. And so, unfortunately, the framework assumed that type of environment was going to persist,” said former Boston Fed president Eric Rosengren, in an interview.

...Powell, a lawyer by training who worked for years as a partner at the Carlyle Group, a private-equity firm, was very skeptical of economic models and forecasts...

This led the Powell Fed to shift to “an outcome-based reaction function” from a prior reliance on forecasts. In other words, the Fed wanted to see “the whites of the eyes” of inflation rather than anticipating its presence over the horizon.

The market understood from Powell and other Fed officials that ending bond purchases was a precondition to any rate hike. For the market, as long as the Fed was buying assets, it was not going to raise rates. In the last cycle, the Fed waited two years between ending purchases and hiking rates.

The rate-hike guidance came first in September 2020. The Fed said it wouldn’t raise its benchmark rate from close to zero “until labor-market conditions have reached levels consistent with the [Fed interest-rate committee’s] assessment of maximum employment and inflation has risen to 2% and is on track to moderately exceed 2% for some time.”

In December 2020, the Fed followed up and gave forward guidance that it would keep buying bonds at the $120 billion monthly pace “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.”

While the Fed never defined “substantial further progress,” financial-market participants took it as a clear sign that the Fed wouldn’t even think about raising interest rates until 2022. This ended all talk of tapering bond purchases for six months. Meanwhile, inflation pressures gathered steam.

If Powell has been backed into a corner by the Federal Reserve's own policy stance, that means to be consistent they will have to keep rates high - or keep raising them - until long after the recession has started, when the final data arrive. I would place a bold bet on the FFR being higher than 5.25% by late summer, but what gives me pause is the rising likelihood of an "event" due to the speed of the recent rate hikes that would serve as a reason for the FOMC not to keep hiking rates. 

[ChpBstrd]

Key quotes from Powell's conference:
Source: https://www.youtube.com/watch?v=CUx1RNvZ8z0

There is significant uncertainty about that level of interest rates [sufficient to bring inflation to 2%]. Even so, we still have some ways to go, and incoming data since our last meeting suggests that the ultimate level of interest rates will be higher than previously expected.

Powell later clarified at about 10:00 that the data points he was talking about here were CPI and employment numbers.

In response to a question about when the FOMC will know when it is time to slow or stop the rate of rate increases.
7:59

...We will be looking at real rates, for example, all across the yield curve...

This is a clue that the Taylor Rule has entered Powell's thinking. Real rates are currently negative across the yield curve, which is an anomaly.

I don't think we've over-tightened. I think it's very difficult to make the case that our current level is too tight, given that inflation still runs well above the Federal Funds Rate.

This is a 2nd clue that it is dawning on the FOMC that rates will have to come up to meet inflation, unless inflation crashes during a recession.

And then the bombshell, in response to a question from the Wall Street Journal at about 12:47 about whether the FFR will need to go above Core CPI.

"This is the question of does the policy rate needs to get above the inflation rate, and there are a range of view and that's the classic Taylor Principal.... I think the answer is we'll want to get the policy rate to the level where the real interest rate is positive... You put some rate on that and you also put some weight on rates across the curve. Very few people borrow at the... federal funds rate for example. ... Households and businesses ... there are meaningfully positive interest rates across the curve for them."
Powell also clarified that this was not the one thing they will be looking at.   

We're 18 months into this episode of high inflation and we don't have a clearly identified scientific way of understanding at what point inflation becomes entrenched...

Good admission. I agree.

From a risk management standpoint, we have to be sure that we don't make the mistake of failing to tightening or loosening policy too soon.

This was in the context of Powell contrasting the risk of overtightening - which can be fixed with policy tools - versus under-tightening, which would allow inflationary expectations to set in. So the Fed is clearly more afraid of an inflationary cycle than a recession - or maybe they've accepted a recession and want to avoid the inflationary expectation cycle.

It's premature to discuss pausing. It's not something we're thinking about...

Powell also agreed that the window for a "soft landing" has narrowed.

Markets tanked when the markets heard Taylor Rule talk and an emphasis on "ongoing rate increases" and "a ways to go" with the rate hikes, phrases that were repeated multiple times. They didn't like that last question which popped the talk about a pause after December.

Overall, Powell's press conference support my hypothesis that the future looks like this:

1) The FFR will go well above 5% before this episode of inflation is over. 7% is not an unreasonable estimate of the peak, because that's above Core CPI, and would flip real yields from negative to positive.

2) A severe recession will result, probably starting in late 2023.

3) The Fed will not immediately come to the economy's rescue, as in past recessions, because the FOMC remains committed to its new policy framework of dismissing forecasts and only making changes after months of data supporting the change are recorded. Additionally, the Fed is more worried about inflation expectations than they are about a recession. These two reasons support one another, and suggest a 6-12 month lag after a recession becomes obvious before rates are cut. This will increase the severity of the recession.

4) The S&P500 will fall to a PE ratio (against pre-recession earnings) in the low to mid teens within the next 2 years, due to the combined effects of a higher discount rate and lower earnings forecasts. It simply does not make sense to pay today's earnings yield of 5.13% if treasuries will be yielding more than that by early summer.

5) There will be an elongated period of time between peak recession panic and the FOMC's first rate cut when it will be very difficult to decide whether to lock in temporarily high yields on fixed income, or to buy stocks at massive discounts. I.e. do you buy long-duration bonds yielding 8-9% or do you buy stocks with a forward estimated earnings yield near 10%? The bonds will rapidly appreciate with the Fed's rate cuts, but will stocks appreciate faster or slower than the bonds? An appealing play is to buy the bonds amid the panic, sell them for a profit with the proceeds after interest rates have fallen, and then buy stocks and call options while earnings are still down. This play is less reliant on getting the timing perfectly right than a plan to go from cash to stocks at the bottom, and it takes less guts to dive into bonds amid financial chaos than it does to catch the falling stocks knife.

[dividendman]

@ChpBstrd So you're saying, if your predictions come true, that putting cash today into a 26 week T-Bill (yielding ~4.5%) is the way to go?

[PDXTabs]

Overall, Powell's press conference support my hypothesis that the future looks like this:

1) The FFR will go well above 5% before this episode of inflation is over. 7% is not an unreasonable estimate of the peak, because that's above Core CPI, and would flip real yields from negative to positive.

I agree entirely that we can expect the fed to hike past whatever core PCE (5.1% last month) is. In normal times with core PCE running at 5.1% you would expect a terminal rate of ~7.1%. I do think that there is an argument to be made that the housing market cool-down, spending down pandemic relief savings, and improving supply chains mean that we don't make it to that point this time. Because "this time is different."

[MustacheAndaHalf]

7:59

...We will be looking at real rates, for example, all across the yield curve...

This is a clue that the Taylor Rule has entered Powell's thinking. Real rates are currently negative across the yield curve, which is an anomaly.

During Q&A, Chair Powell said there are a range of views, including the classic Taylor rule, but said you want something more forward looking.  I took that as dismissing the Taylor rule in favor of forward looking measures.
https://www.youtube.com/watch?v=CUx1RNvZ8z0&t=765s

[EscapeVelocity2020]

https://youtu.be/CUx1RNvZ8z0?t=987

I found this admission about not really knowing what is going on to be bracingly honest for Fed-speak!  Buckle up everyone, Powell is more worried about not tightening enough or staying restrictive long enough...

[SilentC]

https://youtu.be/CUx1RNvZ8z0?t=987

I found this admission about not really knowing what is going on to be bracingly honest for Fed-speak!  Buckle up everyone, Powell is more worried about not tightening enough or staying restrictive long enough...

But my ReALtOr says I should buy NOW and refinance next year when mortgages are 4%.  I’m in a quandary, should I believe her or the Fed?!  Do you think higher and longer means they will start doing 75bp cuts in December in time for me to refi next year?! 

[dividendman]

https://youtu.be/CUx1RNvZ8z0?t=987

I found this admission about not really knowing what is going on to be bracingly honest for Fed-speak!  Buckle up everyone, Powell is more worried about not tightening enough or staying restrictive long enough...

But my ReALtOr says I should buy NOW and refinance next year when mortgages are 4%.  I’m in a quandary, should I believe her or the Fed?!  Do you think higher and longer means they will start doing 75bp cuts in December in time for me to refi next year?!

If you can't afford the current rate you shouldn't purchase the house. Nobody knows how long rates will remain at these (or higher) levels.

[ChpBstrd]

@ChpBstrd So you're saying, if your predictions come true, that putting cash today into a 26 week T-Bill (yielding ~4.5%) is the way to go?

I have no good arguments against that plan, other than to maybe consider waiting another 5 weeks to get a rate 0.5% to 0.75% higher.

I agree entirely that we can expect the fed to hike past whatever core PCE (5.1% last month) is. In normal times with core PCE running at 5.1% you would expect a terminal rate of ~7.1%. I do think that there is an argument to be made that the housing market cool-down, spending down pandemic relief savings, and improving supply chains mean that we don't make it to that point this time. Because "this time is different."

Yea when we're pondering what the Fed will do in March or May, we have to make a prediction about where inflation will be by that time. We're looking for the intersection point between the FFR and a moving target of inflation.

That why I've been focused on the theory and data around inflation for this entire thread. Tell me where inflation is heading and I'll tell you where the FFR is heading. I like a Taylor-Rule-like explanation, based on theoretical incentive structures for spending vs. saving and historical behavior of the FFR vs. inflation. I know the best I can do is establish likely boundaries such as how low inflation could be by X time, whether policy is restrictive or stimulative when the FFR is half the rate of CPI, or whether the unemployment rate or the savings rate can go lower than 3.5% each.

I'm not sure anyone knows how much stimulus money is still floating around in the domestic US economy, as opposed to being locked up in treasury bonds or foreign accounts. I suspect businesses are becoming reluctant to invest in additional capacity when they can see the writing on the wall that we're about to have a big recession, so supply chain improvements are probably complete.

WRT the housing market potentially collapsing, I doubt that will be a big impact on housing CPI in the next 6-9 months because, as Powell pointed out, there are sticky prices, lease delays, sale delays, etc. Plus, CPI/PCE is a measurement of what a survey of people are actually paying at any given time, not the current going price for acquiring new housing. The amount actually paid is somewhat locked in for homeowners, landlords, and people on leases.

Our European friends with ARMs may be less lucky. It's odd to me that the latest housing bubble also occurred in a place with such risky loan structures. They're much further out on a limb than most American homeowners, and they were paying similarly high prices without the security of 30 year fixed mortgages. With much higher rates quickly transferring to home payments, soon-to-be higher unemployment,  skyrocketing utilities, and government austerity plans on the way, it remains to be seen if European-style social support nets can prevent a housing collapse. Americans with sub-4% mortgages locked in will cry about their paper losses, but Europeans are facing immediate cash flow issues.

7:59

...We will be looking at real rates, for example, all across the yield curve...

This is a clue that the Taylor Rule has entered Powell's thinking. Real rates are currently negative across the yield curve, which is an anomaly.

During Q&A, Chair Powell said there are a range of views, including the classic Taylor rule, but said you want something more forward looking.  I took that as dismissing the Taylor rule in favor of forward looking measures.
https://www.youtube.com/watch?v=CUx1RNvZ8z0&t=765s

That's a good point about multiple possible interpretations of Powell's remarks. My take on Powell bringing up the Taylor Principal and describing positive real returns across the yield curve as a policy signal was to forewarn markets about what could happen, even as he used vague language about "additional interest rate increases" and "a ways to go" elsewhere in his remarks. I've been looking for a signal that Powell knows rates will likely go much higher than markets currently forecast. There was a shift yesterday to Powell talking about concrete relationships between interest rates in a way I don't think he did in earlier months. I took that as my signal, as did the FFR futures market to a lessor degree. The new consensus is 5.25%, a sudden shift from 5% two days ago.
https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html?redirect=/trading/interest-rates/countdown-to-fomc.html

But you are also correct that Powell very much emphasized how the FOMC is looking at a multitude of economic metrics, not just backward-looking annualized inflation measures. Employment was mentioned a few times, as was international events, business reports, etc. My interpretation was that Powell was buying himself room to maneuver and react to contingencies if necessary, rather than committing to follow a formula in a robotic way. If large banks start collapsing and key markets freeze up like in 2008, the Federal Reserve can pivot policy immediately, rather than waiting for inflation numbers to justify action. Powell still dismissed the idea of relying on forecasts, but he seemed friendlier to the idea of incorporating forward indicators of inflationary or recessionary conditions.

An alternative interpretation might be that Powell believes it may be possible for the FFR to peak after another 100-125bp of rate hikes, and for inflation to fall. Anything could happen, so Powell is perhaps wise to not play the forecaster himself. It's also politically helpful to be as surprised as everyone else when things don't go well and you didn't warn them.

[EscapeVelocity2020]

https://youtu.be/CUx1RNvZ8z0?t=987

I found this admission about not really knowing what is going on to be bracingly honest for Fed-speak!  Buckle up everyone, Powell is more worried about not tightening enough or staying restrictive long enough...

But my ReALtOr says I should buy NOW and refinance next year when mortgages are 4%.  I’m in a quandary, should I believe her or the Fed?!  Do you think higher and longer means they will start doing 75bp cuts in December in time for me to refi next year?!

Hard to tell with the caps if that was meant to be a sarcastic statement, but obviously the realtor wants you to hurry up and buy as much house as you can get a loan for...  Without knowing a whole lotta information, asking an internet stranger probably won't provide the optimum result.

[SilentC]

https://youtu.be/CUx1RNvZ8z0?t=987

I found this admission about not really knowing what is going on to be bracingly honest for Fed-speak!  Buckle up everyone, Powell is more worried about not tightening enough or staying restrictive long enough...

But my ReALtOr says I should buy NOW and refinance next year when mortgages are 4%.  I’m in a quandary, should I believe her or the Fed?!  Do you think higher and longer means they will start doing 75bp cuts in December in time for me to refi next year?!

Hard to tell with the caps if that was meant to be a sarcastic statement, but obviously the realtor wants you to hurry up and buy as much house as you can get a loan for...  Without knowing a whole lotta information, asking an internet stranger probably won't provide the optimum result.

Yeah that was sarcasm.  Realtors and mortgage bankers I know saying  “Denver only went down 10% in the GFC, will not go down that much for sure, rates will be 4% or 5% again soon, no forced sellers so prices can’t go down” etc.  Fed on the other hand wants to shut off the refi piggy bank, I read there was 1 trillion of cash out refi money in 2021 which is mind boggling if true.  Pivot deniers are running out of arguments why the Fed will pivot barring a hard landing and at that point a 5% mortgage doesn’t mean as much.

[wageslave23]

https://youtu.be/CUx1RNvZ8z0?t=987

I found this admission about not really knowing what is going on to be bracingly honest for Fed-speak!  Buckle up everyone, Powell is more worried about not tightening enough or staying restrictive long enough...

But my ReALtOr says I should buy NOW and refinance next year when mortgages are 4%.  I’m in a quandary, should I believe her or the Fed?!  Do you think higher and longer means they will start doing 75bp cuts in December in time for me to refi next year?!

I think the real estate market has further to fall. When mortgage rates hit 9% there's going to be a lot of carnage, and if unemployment increases then there will be foreclosures flooding the market. So the idea is good, just jumping the gun on the timing.

[SilentC]

https://youtu.be/CUx1RNvZ8z0?t=987

I found this admission about not really knowing what is going on to be bracingly honest for Fed-speak!  Buckle up everyone, Powell is more worried about not tightening enough or staying restrictive long enough...

But my ReALtOr says I should buy NOW and refinance next year when mortgages are 4%.  I’m in a quandary, should I believe her or the Fed?!  Do you think higher and longer means they will start doing 75bp cuts in December in time for me to refi next year?!

I think the real estate market has further to fall. When mortgage rates hit 9% there's going to be a lot of carnage, and if unemployment increases then there will be foreclosures flooding the market. So the idea is good, just jumping the gun on the timing.

Lyft and Stripe announced -13% headcount reductions today and Twitter 25% and FB essentially in a hiring freeze and the other big tech names pulling back in hiring.  Tech is not yet cheap nor are houses especially when you consider tech remote working was very disruptive to low cost markets like Boise, Denver, Tampa, etc.  edit- Amazon just said they are freezing corporate hiring.

[EscapeVelocity2020]

https://youtu.be/CUx1RNvZ8z0?t=987

I found this admission about not really knowing what is going on to be bracingly honest for Fed-speak!  Buckle up everyone, Powell is more worried about not tightening enough or staying restrictive long enough...

But my ReALtOr says I should buy NOW and refinance next year when mortgages are 4%.  I’m in a quandary, should I believe her or the Fed?!  Do you think higher and longer means they will start doing 75bp cuts in December in time for me to refi next year?!

Hard to tell with the caps if that was meant to be a sarcastic statement, but obviously the realtor wants you to hurry up and buy as much house as you can get a loan for...  Without knowing a whole lotta information, asking an internet stranger probably won't provide the optimum result.

Yeah that was sarcasm.  Realtors and mortgage bankers I know saying  “Denver only went down 10% in the GFC, will not go down that much for sure, rates will be 4% or 5% again soon, no forced sellers so prices can’t go down” etc.  Fed on the other hand wants to shut off the refi piggy bank, I read there was 1 trillion of cash out refi money in 2021 which is mind boggling if true.  Pivot deniers are running out of arguments why the Fed will pivot barring a hard landing and at that point a 5% mortgage doesn’t mean as much.

Phew, I'm almost 50 so my internet sarcasm detection is feeble at best!  "Prices can't go down" - famous last words...  sadly most bankers and realtors truly believe their sales pitches.

[ChpBstrd]

Check out this fun chart. The spread between 2y and 10y treasuries hit -0.51%. That exceeds 1989, 2000, and 2006-2007.


One year treasuries yielded 4.76% yesterday, and were the peak of the yield curve. The timing on that bond is actually attractive, because stocks will probably be cheaper by then and because it's competitive with the 5.13% earnings yield on stocks.

One might think the bursting of the October bear market rally would be a good time to go heavily short the market, but I think the xmas shopping season will be a blockbuster this year, and that could float prices upward through December.

[BicycleB]

Taking a longer term perspective, the National Bureau of Economic Research recently published a paper suggesting that real long term interest rates from the safest available lender (?) have trended downwards from the year 1331 until 2021. My apologies if this has been discussed in this thread. Here's the link to their pdf of working paper 30475, "Long-Run Trends in Long-Maturity Real Rates 1331-2021", available as one of three free downloads per year for readers who don't have a subscription.

https://www.nber.org/papers/w30475

Hat tip to @SeattleCPA, who started a thread on the topic (https://forum.mrmoneymustache.com/investor-alley/long-run-trend-in-long-term-interest-rates-down-1-6-every-century/msg3075530/#msg3075530) and links from the thread to a thought-provoking post on the topic that he issued on his public blog. I extracted data from the article, calculated trend expectations and offered initial discussion in that thread as linked below. One calculation result was that real rates near zero for the next few decades would be on trend. However, it should be noted that:

1. Real rates for the past century were near zero too so arguably our retirement calculators are based on similar data if I understand correctly.
2. However, that pertains to bonds - no idea if this implies stock prices are similarly reliable, they might not be.
3. Short term variances of several percent per year are common in the real interest rates, and compounding variances above or below trend can last for decades if I am reading the graphs correctly, perhaps temporarily causing outcomes very different from trend.

As an example of point 2, the 1970s are part of a visible swing on the graphs, not a brief spiky dip like 2022 would be if inflation fell next year. Negative real rates compounding for a decade are different from just a year, and the record includes such episodes as part of "average real rates near zero."

https://forum.mrmoneymustache.com/investor-alley/long-run-trend-in-long-term-interest-rates-down-1-6-every-century/msg3076394/#msg3076394

[MustacheAndaHalf]

7:59

...We will be looking at real rates, for example, all across the yield curve...

This is a clue that the Taylor Rule has entered Powell's thinking. Real rates are currently negative across the yield curve, which is an anomaly.

During Q&A, Chair Powell said there are a range of views, including the classic Taylor rule, but said you want something more forward looking.  I took that as dismissing the Taylor rule in favor of forward looking measures.
https://www.youtube.com/watch?v=CUx1RNvZ8z0&t=765s

That's a good point about multiple possible interpretations of Powell's remarks. My take on Powell bringing up the Taylor Principal and describing positive real returns across the yield curve as a policy signal was to forewarn markets about what could happen, even as he used vague language about "additional interest rate increases" and "a ways to go" elsewhere in his remarks. I've been looking for a signal that Powell knows rates will likely go much higher than markets currently forecast. There was a shift yesterday to Powell talking about concrete relationships between interest rates in a way I don't think he did in earlier months. I took that as my signal, as did the FFR futures market to a lessor degree. The new consensus is 5.25%, a sudden shift from 5% two days ago.
https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html?redirect=/trading/interest-rates/countdown-to-fomc.html

But you are also correct that Powell very much emphasized how the FOMC is looking at a multitude of economic metrics, not just backward-looking annualized inflation measures. Employment was mentioned a few times, as was international events, business reports, etc. My interpretation was that Powell was buying himself room to maneuver and react to contingencies if necessary, rather than committing to follow a formula in a robotic way. If large banks start collapsing and key markets freeze up like in 2008, the Federal Reserve can pivot policy immediately, rather than waiting for inflation numbers to justify action. Powell still dismissed the idea of relying on forecasts, but he seemed friendlier to the idea of incorporating forward indicators of inflationary or recessionary conditions.

An alternative interpretation might be that Powell believes it may be possible for the FFR to peak after another 100-125bp of rate hikes, and for inflation to fall. Anything could happen, so Powell is perhaps wise to not play the forecaster himself. It's also politically helpful to be as surprised as everyone else when things don't go well and you didn't warn them.

I suspect core PCE has more influence on the Fed than other measures.  First, it's fairly stable, around 5% now.  Core CPI is all over the place, making it hard to rely on or cite as "core" inflation.

My biggest surprise was subtle: CNBC's Steve Liesman wasn't at the Nov Fed meeting, and I wonder where he was, and when I can get his take on the Fed.  It was Mr Liesman who got the Fed to commit to not using a 0.75% rate hike... and then they did just that a month later.  (They laughed about it later, with Chair Powell saying at one meeting "And I should know better than to answer your second question", a reference to mistakenly taking 0.75% off the table).  I view Steve Liesman as an expert on the Fed, so it will help to hear his take on peak Fed funds.

If inflation is much higher than expected, that could mean 5.25% instead of 4.50% peak inflation.  I assume the Fed will offer more details later, perhaps after the mid-term election.  And I think being a little vague ("very uncertain") is appropriate, which leaves him room to push close to 6% if needed.

Core PCE is around 5% right now, so if it fell then 4.50% peak Fed funds makes sense.  I suspect core PCE is the measure we should weigh the heaviest, and if it goes up that makes 5.5% more likely.

[EscapeVelocity2020]

I agree that the midterm elections caused Powell to be especially nebulous and careful not to crater the economy (unintentionally feeding the narrative that the Dems are solely responsible for this terrible economic situation and to vote accordingly).  I have a feeling, once the smoke clears from Nov8th, we will begin to get more clarity about how much work the Fed really thinks it needs to do.  I tend to think the messaging will become more bluntly hawkish.  Powell went to great lengths to point out that Fed posturing has significant effect on the economy and ultimately interest rates.  I believe he intends to use this policy tool more aggressively if the data continues to remain stubbornly inflationary.

The Fed Watch Tool currently shows a 52/48 chance between 50 bps and 75 bps December 14th...  I personally think another 75bps is needed in order to make it clear that getting back to 2% inflation is the priority, but I'll be watching to see if Powell guides toward this more clearly as November goes on.  If we get to December with a continued 50/50 probability, the market will go bonkers! 

[ChpBstrd]

I suspect core PCE has more influence on the Fed than other measures.  First, it's fairly stable, around 5% now.  Core CPI is all over the place, making it hard to rely on or cite as "core" inflation.
...

If inflation is much higher than expected, that could mean 5.25% instead of 4.50% peak inflation.  I assume the Fed will offer more details later, perhaps after the mid-term election.  And I think being a little vague ("very uncertain") is appropriate, which leaves him room to push close to 6% if needed.

Core PCE is around 5% right now, so if it fell then 4.50% peak Fed funds makes sense.  I suspect core PCE is the measure we should weigh the heaviest, and if it goes up that makes 5.5% more likely.

Now that's a perspective that shakes up my hypothesis! I like it. Perhaps the market believes rates will rise to meet - but not exceed - Core PCE. That would be consistent with how the futures market foresees 5.25% as the peak FFR; that's a quarter-point above Core PCE. This is a very optimistic view of inflation and the amount of rate hikes needed to reduce it. Of course, I have some thoughts:

1) The FFR is routinely hundreds of basis points higher than Core PCE during times when the Federal Reserve is worried about inflation. Any market expectation that rate hikes stop when those lines intersect is not historically supported. Additionally, any expectation that inflation will go down when those lines intersect is not historically supported. Look at the ~3% gap in 1965, the ~2% gap in 1972, the ~3% gap in 1979, or the ~3% gap in 1987, each of which was insufficient to prevent Core PCE from rising fast over the following years. In each of those episodes, inflation only peaked after the FFR - Core PCE gap exceeded 4% in 1969, 1974, 1980, and 1988. Thus we should not expect a 0% gap between FFR and Core PCE to reduce inflation or to be anywhere close to the peak of interest rates.


2) Ignoring food and energy inflation is something 1970's Fed chair Arthur Burns is lambasted for. Burns infamously thought the OPEC embargo and a sudden spike in food prices were transitory factors, and ordered the calculation of Core CPI to get at what he thought was the underlying trend. Then he tried to cut more things out of CPI for various excuses - eventually 65% of the things in CPI! - before realizing the error of that approach as inflation raged. Powell should be aware that the Fed will lose credibility if they take that path again, and so I've heard him refer more often to whole measures than core measures. Recall the following article by Stephen Roach:
https://www.marketwatch.com/story/the-ghost-of-arthur-burns-haunts-a-complacent-federal-reserve-thats-pouring-fuel-on-the-fires-of-inflation-11621971073

Also consider what happens when we chart PCE, Core PCE, and FFR together. This chart tells me the following story: Core PCE only declines several months to a year after the FFR matches or exceeds whole PCE!


3) Policy is still stimulative, because negative real rates are discouraging saving and encouraging economic actors to pull ahead purchases. Thus, PCE and especially CPI could accelerate in the coming months. The whole reason the Fed cannot quickly extinguish inflation this time is because they let the FFR get so far below (any measure of) inflation. As noted above, some of the biggest inflation outbreaks have occurred after the FFR was 2-3% above contemporary inflation, and now we are that far below Core PCE. In other words, policy is still highly stimulative, and even at a pace of 0.75% hikes each meeting, the FFR will not intersect with Core PCE and offer a positive real return by that measure for another four months. PCE could accelerate into the headwinds of rising rates just like it did in past inflationary episodes, particularly if wages start rising. As a measure of the amounts people are actually paying for things (rather than just prices as CPI measures), PCE is largely a reflection of wages and the savings rate. Huge gains in job creation and a the lowest savings rate since 2005-06 indicate stimulative conditions and point to immanent upward wage pressures. The "now hiring" signs and bad service everywhere are not illusions - labor supply is not keeping up with demand.
https://www.marketwatch.com/story/coming-up-u-s-jobs-report-for-october-11667563268?mod=home-page
https://fred.stlouisfed.org/series/PSAVERT

I agree that the midterm elections caused Powell to be especially nebulous and careful not to crater the economy (unintentionally feeding the narrative that the Dems are solely responsible for this terrible economic situation and to vote accordingly).  I have a feeling, once the smoke clears from Nov8th, we will begin to get more clarity about how much work the Fed really thinks it needs to do.  I tend to think the messaging will become more bluntly hawkish.  Powell went to great lengths to point out that Fed posturing has significant effect on the economy and ultimately interest rates.  I believe he intends to use this policy tool more aggressively if the data continues to remain stubbornly inflationary.

The Fed Watch Tool currently shows a 52/48 chance between 50 bps and 75 bps December 14th...  I personally think another 75bps is needed in order to make it clear that getting back to 2% inflation is the priority, but I'll be watching to see if Powell guides toward this more clearly as November goes on.  If we get to December with a continued 50/50 probability, the market will go bonkers! 

Bear in mind that Jerome Powell is a Republican with an investment banking background appointed by Trump. He has no reason to like Biden other than perhaps a little bit of gratitude for being renominated. I don't see political manipulation behind his words or actions, though. Even if he believes, as I do, that the FFR is likely to hit 7% sometime next year, and that a massive recession is coming in late 2023, he cannot telegraph these thoughts and intentions to his audience. Powell has to worry about setting off a chain reaction that might catch financial institutions, market makers, and others unprepared. Even his most milquetoast words move stock markets 3-4%, so just imagine the day he accepts the necessity of recession or admits the FFR will have to go above inflation. He could start a riot. Best for him to let the markets work these things out for themselves, as we are doing here!

I also think another 75bps hike is happening in December. To do anything less amid extremely negative real rates would indicate an incorrect view of the severity of the situation on the Fed's part. I would aggressively sell any rally that came from such a taper.

Meanwhile, the seal has been broken and a 6% FFR is now in the Overton Window. Next up, 7%.
https://markets.businessinsider.com/news/stocks/kenneth-rogoff-harvard-inflation-recession-fed-interest-rates-hikes-economy-2022-11?op=1

[ChpBstrd]

It's going to be a volatile week. Now only do midterm results start arriving, but we also have the October CPI releases on Thursday morning! There's also cause for optimism about the upcoming hyper-consumption season.

PPI will be released on 11/15 and the October PCE number doesn't come out until Dec. 1. Inventories are reported on 11/16 as part of the "Manufacturing & Trade Inventories & Sales" release.

Markets have been rallying on the business-friendly prospect of divided government, and also rumors of December's rate hike only being 0.50% and perhaps representing a top or near-top for the Federal Funds Rate. The Federal Funds Rate futures market currently shows a 56.8% probability of a 0.5% hike, and a 43.2% probability of another 0.75%. Only a week ago, a 0.75% hike was considered the most likely outcome.
https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html?redirect=/trading/interest-rates/countdown-to-fomc.html

Of course, I've said for months that we'll have 0.75% hikes through the end of 2022, so what are market participants seeing that causes them to expect a good CPI release on Thursday, and again in December? The same big Christmas season demand everyone is counting on would seemingly negate the chances of a rate hike, right?

The Cleveland Fed's nowcasting tool predicts headline numbers of 8.09% for CPI and 6.58% for Core CPI, slightly lower than the September numbers. The monthly change in CPI would be a lower number than we saw in September, but higher than July and August. The Core CPI monthly change would be a 12-month low. CPI and PCE are forecast to decrease further in November.
https://www.clevelandfed.org/indicators-and-data/inflation-nowcasting

Additionally, one-year forward inflation expectations have fallen from 6.8% in June to only 5.4% today.
https://tradingeconomics.com/united-states/inflation-expectations

However, the GDPNow nowcast estimates GDP growth at a breathtaking 3.6%, far above the consensus of human experts. If that's even close to right, the inflation nowcast and expectations are probably way off. Remember my hypothesis that policy is still actually stimulative? Apparently this model's methodology agrees.
https://www.atlantafed.org/cqer/research/gdpnow

The S&P GSCI commodities index's average closing price in October was 1.06% higher than in September. That's another headwind that will have to be overcome if we are to see a low CPI/Core CPI on Thursday. Yet the trend has clearly flattened since the beginning of this year, and against the 12-months-ago comparison point. I don't have a correlation coefficient to help me understand how closely related commodities are to inflation, but in the medium term we could see a commodities rebound that would raise concerns about the likelihood of a taper-down of inflation.

The Personal Savings Rate released in late October was 3.1%, which is still shockingly low, no doubt unsustainable, and near the 2005 and 2007 lows that were followed by a reversal. I keep watching this trend as a proxy for how inflation and interest rates are incentivizing consumption or savings. When consumers start saving instead of pulling ahead their purchases, demand will drop. Because they have pulled ahead so many purchases over the past 18 months, that drop in demand could be dramatic.
https://fred.stlouisfed.org/series/PSAVERT

There is no dataset for the final thing we should be considering. It's the speed at which 2020-2021 stimulus money makes its way out of the daily economy and into foreign bank accounts and treasuries. Surely by now a lot of that new money is exiting regular circulation in the economy. Evidence for this assertion can be found in the recently reported declining M2 and declining household net worth.
https://fred.stlouisfed.org/series/M2NS
https://fred.stlouisfed.org/series/BOGZ1FL192090005Q

Earlier I interpreted accelerating Velocity of M2 as a sign of an inflationary spiral, but when coupled with a declining M2 money supply, I wonder if it just means the dollars still in circulation have to circulate faster to do the same amount of economic transacting. That's possibly a long-shot interpretation, but it's just as reasonable as explaining the 2020 drop in velocity of M2 as an effect of rapidly increasing money supply pulling down the average velocity. If consumers and their retailers are running out of stimulus money, we could see a drop in consumer spending, markdowns on record inventory levels, and lower price pressures soon-ish. I know my families are looking forward to getting together and doing big post-pandemic celebrations, and I assumed lots of other families were having the same experience, but maybe that won't involve as much spending as I originally thought, amid widespread economic pessimism. I'm tempted to sit out November for clearer signs of a slowdown or burn-up after Black Friday.
https://fred.stlouisfed.org/series/M2V

The Cleveland Fed's nowcast of an 8.09% CPI sounds about right to me, given all the circumstances.

[MustacheAndaHalf]

I suspect core PCE has more influence on the Fed than other measures.
...
Core PCE is around 5% right now, so if it fell then 4.50% peak Fed funds makes sense.  I suspect core PCE is the measure we should weigh the heaviest, and if it goes up that makes 5.5% more likely.

Now that's a perspective that shakes up my hypothesis! I like it. Perhaps the market believes rates will rise to meet - but not exceed - Core PCE. That would be consistent with how the futures market foresees 5.25% as the peak FFR; that's a quarter-point above Core PCE. This is a very optimistic view of inflation and the amount of rate hikes needed to reduce it. Of course, I have some thoughts:

1) The FFR is routinely hundreds of basis points higher than Core PCE during times when the Federal Reserve is worried about inflation. Any market expectation that rate hikes stop when those lines intersect is not historically supported.

I've heard that before - but that's the Taylor Rule?  Fed Chair Powell claimed he is not following it, and is instead watching the data.  What if the FFR always exceeded inflation because the lags were so long, FFR increases were made after they were no longer needed?  The historical examples always end in recession, I believe, which also suggests too many rate hikes were made.

The Fed giving forward guidance really is different this time - it hasn't been done like that before.  The market takes advantage of information, so it has priced in the Fed guidance - and each time the Fed has followed through.  The markets are not reacting to Fed actions, but to Fed guidance.  That in turn could shrink the lag between rate hikes and economic tightening.

Earlier this year I firmly believed in a severe recession.  Historical data shows tightening (QT or equivalent, rate hikes) of this magnitude leads to recession.  We've had the longest bull market in history - defying the business cycle's alternating bull and bear markets.  So there were reasons I believed things would get much worse.

But right now I'm no longer sure.  That's why my biggest holding is the S&P 500, because I'd like to wait and see.  Paul Krugman believes inflation has already peaked, but he might be overly focused on housing (which, admittedly, is a big part of the ecomomy).  Larry Summers expected core PCE to rise before the last CPI report, and it did, reinforcing my belief he's studying the data carefully (he also mentions taking median inflation, middle half inflation, and numerous other measures).

I believe the market's median prediction is a mild recession.  If you have data and experts to dispute that consensus, you can profit off a crash by going to cash or buying put options.  Both of my primary predictions have already come true - yields rose significantly, and recession risk is priced in.  That's why weeks ago I switched to the S&P 500, and am currently waiting it out.

[SpaceCow]

Does anyone have a mental model that explains the low October CPI data (0.3% Core CPI)? I can imagine a few scenarios:

--Noise

--Statistical Error: I have my doubts that the return to in-person CPI data collection is seamless. This goes particularly for used cars and apparel, which I allege may be distorted in the transition from largely online data collection to largely in person data collection. I can imagine how this transition could, in aggregate, skew these indexes. If this is the case, core PCE could depart from the core CPI significantly.

--Krugman's narrative is correct. Inflation has peaked, dragging the brakes with QT and rate hikes did its job, and inflation will continue a downward trajectory. The Taylor rule is no longer useful due to new tools like QT and forward guidance.

Other ideas? I am in the noise/statistical error camp because I am having a hard time untying inflation and employment in my brain. How can things be turning deflationary when the labor market is this tight?

[EscapeVelocity2020]

Does anyone have a mental model that explains the low October CPI data (0.3% Core CPI)? I can imagine a few scenarios:

--Noise

--Statistical Error: I have my doubts that the return to in-person CPI data collection is seamless. This goes particularly for used cars and apparel, which I allege may be distorted in the transition from largely online data collection to largely in person data collection. I can imagine how this transition could, in aggregate, skew these indexes. If this is the case, core PCE could depart from the core CPI significantly.

--Krugman's narrative is correct. Inflation has peaked, dragging the brakes with QT and rate hikes did its job, and inflation will continue a downward trajectory. The Taylor rule is no longer useful due to new tools like QT and forward guidance.

Other ideas? I am in the noise/statistical error camp because I am having a hard time untying inflation and employment in my brain. How can things be turning deflationary when the labor market is this tight?

I'm in the noise camp.  CPI has been crazy hot all year, so maybe it isn't quite so hot for one month.  That doesn't necessarily mean that the Fed's work is done or is even that it is directly responsible for inflation easing.  Consumers could just be hitting a wall.  Longer term, if the Fed eases off the inflation battle too soon, we are likely to be dealing with elevated inflation for longer.  We are still seeing real estate hold its value and change hands quickly all around us, so I don't expect inflation to collapse in the coming months.  That, in my mind, would be the most obvious signal that the increased borrowing rates are having a real effect.

There is also the optimistic possibility that QT is somehow responsible, but I have no data for if that would work practically.