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

[EscapeVelocity2020]

They should also be considering the ex-food and energy read, which isn't quite so clear -



As well as the PCE, which has an update for July on August 31st



Whole lotta squiggling going on

[ChpBstrd]

My interpretations:

<>CPI fell to zero because commodities corrected. Commodities could easily un-correct too.

<>Core CPI is still rising fast because price hikes on consumers are lagging producer prices. I.e. the PPI>CPI back in June.

<>PCE is rising because consumers are pulling forward their future purchases to avoid price hikes, and to lock in favorable rates while they last. This behavior will keep the economy strong in the coming months.

Speaking of purchasing, I did something today that I should have done six months ago: Set up a treasurydirect account and plowed the $10k max into I-bonds for each household member. It's small potatoes, but the yield is currently 9.62% and I have reason to believe it'll stay high enough so that I won't regret holding it for at least a year and even if I cash it out before 5 years to chase other opportunities, losing the last 3 months of interest will have been worth it (because in a scenario where I'd do that, the interest rate would be very low). This is not a get-rich move, but I cannot pass that up.

[MustacheAndaHalf]

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

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

I would say the question is interesting, rather than being tough.  Focusing on active investing, I view the market as having only two interesting sources:
(1) the investment thesis of broad parts of the market.  If numerous professional investors believe something, that's interesting for the money behind that belief.
(2) experts who may have a more accurate understanding of future events

But defining "experts" is interesting and maybe tough.  Certainly people with a journalism degree lacking investment experience aren't experts.  Investment managers might be experts, but I tend to lump them in (1), as they represent views on how the market invests money.  I would view people holding top positions at big name investment firms as experts, and economists with some investment background would be in that group as well.

For me personally, I'm looking for a gap between (1) and (2).  When a large chunk of the market prices in probably incorrect information, there's room for active investment.  The group favoring a soft landing and falling inflation is add odds with an economist who says rental prices are still being incorporated into CPI inflation.  That's evidence of a gap, and if there's enough other evidence then I consider it investible.

Currently, I suspect September has volatility and market drops.  But I'll be looking into that further over the next couple weeks, where I will increasingly ignore articles by those who have nothing to recommend them as experts.

[ChpBstrd]

Here's an interesting checklist for a "bottom is in" signal:

1) S&P500 trailing PE plus inflation < 20,
2) Fed cuts rates, with a 50bp or more decline in 2y treasuries,
3) unemployment rising
4) ... cannot find the remaining checklist items because no link

https://www.marketwatch.com/story/this-rule-with-a-perfect-record-says-the-market-hasnt-bottomed-says-bank-of-americas-star-analyst-11660809885?mod=mw_more_headlines

[blue_green_sparks]

Here's an interesting checklist for a "bottom is in" signal:

1) S&P500 trailing PE plus inflation < 20,
2) Fed cuts rates, with a 50bp or more decline in 2y treasuries,
3) unemployment rising
4) ... cannot find the remaining checklist items because no link

4) Apes stop betting on meme stonks?

[Jeferson]

In the Czech Republic, the country where I live is according to https://tradingeconomics.com/czech-republic/inflation-cpi inflation rate 17.2 and it is very visible in every shop you go to. And the interest rates that banks offer are roughly 4%, so having your money in a savings account is a thing that we all are trying to avoid here lately. It's interesting to see such high-interest rates in one of the EU countries when for instance South Africa has an inflation rate hovering around 7%

[ChpBstrd]

In the Czech Republic, the country where I live is according to https://tradingeconomics.com/czech-republic/inflation-cpi inflation rate 17.2 and it is very visible in every shop you go to. And the interest rates that banks offer are roughly 4%, so having your money in a savings account is a thing that we all are trying to avoid here lately. It's interesting to see such high-interest rates in one of the EU countries when for instance South Africa has an inflation rate hovering around 7%

It would seem like you could go to the bank and take out a loan for slightly over 4%, buy a bunch of inventory, and then sell it a year later for a profit of inflation rate minus interest rate. Obviously if you are a retailer or a consumer, it makes sense to buy things now rather than waiting for the price to rise further. For investors, maybe precious metals or other commodities are the place to be.

We're in a weird spot for sure, and as you can see as long as this inflation>interest dynamic continues, the longer people will be incentivized to hoard and lock in prices.

[ChpBstrd]

The National Financial Conditions Index fell today, which means it is becoming easier to finance loans. This is yet another metric that is anti-recession and pro-inflation. The NFCI is a major advance predictor of recessions, and it has shifted to moving away from recessionary conditions.

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

Also, the manufacturing reports out today tell of story of steady demand from consumers. Durable goods orders were basically flat compared to June. In several sectors new orders rose.

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

The Biden administration announced $10k student loan forgiveness for most borrowers, a 4-month extension on the payments moratorium, and the option to cap repayment of student loans at 5% of income. This is yet another pro-growth, pro-inflation factor.

All this "good" news is likely to be read with a frown by the central bankers at Jackson Hole. They might be hoping for a quick recession in Q4 or Q1 that will eradicate inflation while not requiring too many more rate hikes. Here we have yet another sign that consumers are pulling ahead purchases, economic growth is strong, and inflation will only be put down in the end by aggressive tightening of financial conditions. The FOMC is no doubt dealing with internal tensions about whether to minimize the damage by killing inflation slowly - like over the course of the next 2 years, or whether to go all-Volker, re-establish credibility, and accept the inevitable recession.

I'm sure they are equally fearful of (a) causing a severe recession when a minor recession was on the way to reduce inflation anyway, and (b) of falling into the 1970's trap of complacency, when inflation was declared defeated multiple times, rates were cut, and inflation came roaring back.

The Fed got into this mess by re-fighting the last battle, a deflationary recession caused by a pandemic, when in hindsight they should have been looking ahead. So maybe we'll see less talk about backward looking "data dependency" and more talk about forward-looking management of the recession that will occur due to the inevitable interest rate hikes. They can't say they are planning a recession, but they can plan around the recession. If they talk a lot about the lower July (and maybe August) CPI numbers, that signifies a shift from data dependency to trend extrapolation.

The ECB is probably among the voices at Jackson Hole calling for an extended gradual approach. A quick hike in rates is the last thing Italy needs, but a prolonged period of inflation might be exactly the lifeline Italy need to dig out of - or more likely manage for another year - their national debt burden. Additionally, the European energy crisis has all but assured a recession will start there sooner than in the U.S. so the ECB is probably less worried about the risk of letting inflationary expectations set in while dovishly awaiting a recession that doesn't come soon enough. The FOMC will have to consider that if they go aggressive, they might be alone in that quest, and might only cause further appreciation of the USD. For Americans, that would be the "everything's cheaper but I can't get a job" scenario, and then the Fed gets criticized for causing that kind of recession 12 months from now when all they had to do was wait for the Eurozone's recession to drag down worldwide economic activity.

[clifp]

The ECB is probably among the voices at Jackson Hole calling for an extended gradual approach. A quick hike in rates is the last thing Italy needs, but a prolonged period of inflation might be exactly the lifeline Italy need to dig out of - or more likely manage for another year - their national debt burden. Additionally, the European energy crisis has all but assured a recession will start there sooner than in the U.S. so the ECB is probably less worried about the risk of letting inflationary expectations set in while dovishly awaiting a recession that doesn't come soon enough. The FOMC will have to consider that if they go aggressive, they might be alone in that quest, and might only cause further appreciation of the USD. For Americans, that would be the "everything's cheaper but I can't get a job" scenario, and then the Fed gets criticized for causing that kind of recession 12 months from now when all they had to do was wait for the Eurozone's recession to drag down worldwide economic activity.

That's a very interesting take,one I hadn't thought of. I'm pretty sure the student loan action will be viewed as inflationary, but I'm not sure if that isn't already baked into the credit markets.
Winter is coming in Europe, and I be surprised if Russia doesn't shut down gas or oil shipments, to one or more European countries, both as  a warning shot to countries helping Ukraine and also and excuse to push energy prices upwards. I don't see how Europe avoids a recession, which probably drags the US into one also.

[ChpBstrd]

The Federal Reserve should continue raising its benchmark interest rate until it is over 3.4% and then “sit for a while,” said Philadelphia Fed President Patrick Harker on Thursday.

“We don’t need to rush way up and then rush way down,” Harker said, in CNBC interview from the Fed’s retreat in Jackson Hole.

“We need to go up and sit for a while and let things play out,” he added. When rates are above 3.4%, they will begin to slow down the economy, he said.

From https://www.marketwatch.com/story/feds-harker-says-hed-like-to-get-benchmark-rate-above-3-4-and-then-sit-for-a-while-11661438961?mod=mw_latestnews

Well that's certainly bullish on stocks, but anxiety-provoking for anyone concerned about a rationalization-led repeat of the 1970s. It also shows a pivot from data dependency to forecasting. Still, the goalpost for "neutral" has shifted from 2.5% to 3.4%, at least in Harker's mind.

Regarding a 0.75% vs. a 0.5% rate hike:

Harker said he would wait for the August inflation data and then decide.

And... that's the signal I was looking for that I mentioned yesterday. The FOMC appears to be forecasting a recession by the end of this year that will be sufficiently big to knock out 8.5% inflation, raise unemployment, and negate the need for rate hikes. They are about to make policy based on this forecast too!

In an ironic twist, the BLS today released a large revision to 2nd quarter GDP.  Turns out, GDP declined 0.6% in Q2, not 0.9%. Maybe the economy isn't so bad after all?

Yet there's something about the timing of this comment: Was Harker testing the waters or preparing the public for Powell's speech? Or was Harker front-running the decision and applying pressure in a power play to get his way? The comments could also be a way to cut off market speculation about rate cuts occurring in early 2023, before Powell sends a similar message tomorrow. Maybe the priority isn't so much getting inflation down ASAP, as it is about being smooth and gradual. Harker's comments about 0.5% hikes being plenty big are along this line of thought. 

In addition to my purchases of I-bonds for the whole family this week, I picked up $30k worth of IAU today. Gold has been in freefall since April due to expectations about higher rates and lower consumption and there are conspicuously few headlines about gold in the financial media. So far it looks like the economy is running strong and the Fed is getting dovish so expectations might shift in the short term. Nonetheless, I'll be hedging this gold position with a put as soon as I get a good order fill. I can hedge until January against a decline bigger than 7% for the cost of about 1.2% of the position. I'll hopefully exit the trade for a small gain within the next month or two. This is not a long-term holding because gold tends to do poorly in recessions OR rising rate environments, and we're eventually heading toward one and/or the other. This might turn out to be a bet on Powell saying soothing words and markets realizing that a recession is farther away than the consensus after tomorrow's initial claims report.

[clifp]

In addition to my purchases of I-bonds for the whole family this week, I picked up $30k worth of IAU today. Gold has been in freefall since April due to expectations about higher rates and lower consumption and there are conspicuously few headlines about gold in the financial media. So far it looks like the economy is running strong and the Fed is getting dovish so expectations might shift in the short term. Nonetheless, I'll be hedging this gold position with a put as soon as I get a good order fill. I can hedge until January against a decline bigger than 7% for the cost of about 1.2% of the position. I'll hopefully exit the trade for a small gain within the next month or two. This is not a long-term holding because gold tends to do poorly in recessions OR rising rate environments, and we're eventually heading toward one and/or the other. This might turn out to be a bet on Powell saying soothing words and markets realizing that a recession is farther away than the consensus after tomorrow's initial claims report.

I have to say my Gold purchases at the beginning of the year, are by far my biggest disappointment mistake. Traditional golds does well in times of high inflation, but not this time.  It is loss less than long bonds or stocks, but I thought it would go up modestly or at least not go down.

I still I'm on fence about permanently keeping 10% in gold/gold stock based on the historical benefits of adding some gold to a portfolio.  But, if any of you are on considering buying gold, you might want to wait until to sell mine, cause there is an excellent chance it will go up after I sell it ;-)

[MustacheAndaHalf]

Yet there's something about the timing of this comment: Was Harker testing the waters or preparing the public for Powell's speech? Or was Harker front-running the decision and applying pressure in a power play to get his way?

Maybe those comments are meaningful, but Harker is not a voting Fed member this year.  His opinions will not determine Fed policy.

In my limited understanding of Fed hawks and doves, hawks want more rate hikes.  Harker is one of the most dovish members, so I think he's just reiterating his desire for fewer rate hikes.  But when it comes to a vote, he won't be involved until next year.
https://www.itcmarkets.com/hawk-dove-cheat-sheet-2/

[ChpBstrd]

Powell's comments today left me with the following impressions:

1) The emphasis on the central banks' determination to act decisively to reduce inflation, and its willingness to inflict "pain" on households, was a shot across the bow for traders expecting a 0.5% hike next month, or rate cuts next year. Powell directly stated that rates will have to be kept high for an extended time and boldly cited the mistakes of the 1970s when rates were cut too soon and inflation came roaring back. For example, the annual rate of inflation fell below 3% in August 1972, but that was only a prelude to a second round of inflation. Those rate cuts from 9.2% to 3.3% occurred over more than 3 years and occurred in the context of a severe recession with rapid disinflation. Is Powell saying don't expect rate cuts for the next 3 years even if there's a severe recession like in 1970? That same pattern repeated in 1974-75, when a severe recession sent inflation plummeting to 5.5% and the Fed cut rates to below CPI. We all know things got worse from there, with unemployment peaking at 10.8% in 1982. Maybe it's all posturing, but these are bold analogies suggesting Powell is moving in a hawkish direction and pointing to mistakes that were made very gradually compared to today's pace of change.



2) Powell's citations of Paul Volcker and Ben Bernanke were about controlling inflation expectations. This is another example of the shift from data dependency to forecasting, and using the credibility of others to justify a return to previously / typically unsuccessful forecasting exercises (recall the series of failed projections for rising inflation during the 20teens). Of course, what's not mentioned is how forecasts of falling inflation are also what persuaded the Fed to cut rates at inopportune times during the 1970s. Maybe their working model is to bring rates to their idea of "restrictive" territory quickly (i.e. 4%) and then not shift to relying on forecasts to cut rates during the recession that follows. If this talk turns into action, there may be a very extended (as in, 2-3 years) bear market when the recession does hit, and short funds will be the game to play starting next spring. But my question is what happens if the recession doesn't come in time? Will the Fed sit a while, as Harkin said, for the first six months of 2023, even as economic growth and inflation remain high? How long could they "sit" before worries about inflation expectations and runaway inflation got to them?

3) The comment about how inflation is caused by "strong demand and constrained supply, and the Fed's tools work principally on aggregate demand" may have been intended to introduce listeners to the concept that hardship lies ahead, but it also demonstrates a Keynesian view of economics. Maybe it is naive to think a central banker would take a monetarist approach and admit that inflation always and everywhere is a monetary problem, because they are the ones who created that money. Maybe this explains the Fed's reliance on interest rates over QT. Powell does not see how QT affects aggregate demand, whereas a modern monetarist might prescribe QT to reel in the extra money supply introduced during the pandemic (I read Keynes a little differently and think reeling in liquidity is consistent with his point about using government activity to smooth the business cycle, but mine is a minority position in a world of absolutists.). Powell's focus on aggregate supply and demand was, in context, about consumption, not money supply. Thus it seems unlikely we'll see an increase in QT. Also I read an offhand comment somewhere about the Fed's reluctance to do anything which might impact bank reserves prior to a probable recession, though I do not fully understand how that would be the case.

M2 and Velocity of M2 numbers were released this week. Money supply has been flat for months, but the velocity of M2 has been increasing for three quarters now. Consumers and businesses are generally still hoarding a lot of cash, but as they pull ahead purchases to avoid price hikes, the pace of money changing hands is increasing.
https://fred.stlouisfed.org/series/M2NS
https://fred.stlouisfed.org/series/M2V

4) The FOMC clearly does not want to communicate anything suggesting what I suspect: inflation will only go down when the FFR exceeds CPI and a major recession occurs. They are guiding market expectations into a narrative in which 4% interest rates and mild QT are all it takes to knock down inflation. Powell is also starting to talk about how this will involve "pain" which means they are recession planning. If the recession comes quickly, they will have warned us about the "pain" and the lack of rate cuts coming to the rescue this time. If the recession comes slowly, then maybe the "pain" will be in the form of a long series of rate hikes beyond 4%, and they will have warned us of that too. Neither of these painful worlds are a place where stocks or bonds will do well. Of course, sometimes the only possible thing that can happen is the thing no traders expect. Dark horse outcomes seem to arise in financial markets as a natural reaction against everyone's expectations. Short squeezes, stocks peaking right before a recession despite worsening data, and stocks climbing the post-recession wall of worry are examples. We could find ourselves in a deflationary environment in the next half or next quarter, with markets wondering if the Fed will stick to its word about no rate cuts for an extended time.

Here's the direct source for Powell's speech. Are your impressions the same as mine? Did I miss anything?
https://www.youtube.com/KansasCityFed

[ChpBstrd]

It is entirely “plausible” that the Fed raises its benchmark rate to 4% this year and then undertakes a string of quarter-percentage-point rate hikes in 2023 to get up to 5.5%, Furman said, in an interview with MarketWatch on the sidelines of the Fed’s summer retreat in Jackson Hole, Wyo.

Furman said he likes to refer to the situation as featuring wage and price “persistence” rather than a “spiral” because inflation is not spinning out of control but is holding its own and has staying power. It is likely that inflation “comes down very slowly,” he added.

The likelihood of a recession in the next nine months is relatively small, Furman said.

https://www.marketwatch.com/story/jackson-hole-notebook-furman-says-feds-benchmark-rate-could-hit-5-5-next-year-11661615968?mod=economy-politics

Finally here's someone who's thinking beyond December and not assuming a recession in 2022.

[wageslave23]

https://www.msn.com/en-us/money/markets/wharton-professor-jeremy-siegel-says-most-inflation-data-is-coming-in-below-expectations-and-the-feds-hawkish-outlook-is-at-odds-with-economic-reality/ar-AA11p9nf?li=BBnbfcL
This guy has a good point. Why is Powell making statements about next year? They have been consistently wrong with their predictions for the past 18 months. Just stick to the short term and try to get that right.

[ChpBstrd]

https://www.msn.com/en-us/money/markets/wharton-professor-jeremy-siegel-says-most-inflation-data-is-coming-in-below-expectations-and-the-feds-hawkish-outlook-is-at-odds-with-economic-reality/ar-AA11p9nf?li=BBnbfcL
This guy has a good point. Why is Powell making statements about next year? They have been consistently wrong with their predictions for the past 18 months. Just stick to the short term and try to get that right.

I think Powell had to express determination and warn of painful future rate hikes because the markets had/have an unrealistically dovish outlook. Powell is both covering himself against any accusations that higher-than expected rates were not forewarned and also actively trying to talk inflation down.

When he implies a much higher rate trajectory that involves "pain", people who were thinking about loading up on inventory, hiring more workers, or expanding their businesses take note and reduce their planned expenditures and use of debt. If they cut spending, or at least stop hoarding goods in anticipation of higher prices, aggregate demand and inflation goes down. It has been weird to see stocks and bonds tanking this week, as if people just got the memo that inflation is over 8% and lots of rate hikes beyond 4% could be coming. Do they not read the MMM Forum?!

A less benign interpretation is that Powell is hoping the FOMC can use tough language to force inflation down because (a) they don't want to raise rates 0.75% for the next 6 meetings, and (b) they cannot raise rates above inflation any time soon. We might be starting the "Whip Inflation Now" sloganeering phase. If Powell suspects, as I suspect, that policy is inflationary anytime the FFR<CPI, then he knows he is so far behind that tough talk is his only weapon to hold back inflation for the next 6-10 months until rates catch up with inflation or a recession strikes.

Regarding the claim that the July data signal the turning point for inflation, it simply looks to me like commodities speculation peaked in June and then the bubble deflated. That's all we need to know to predict a minor dip in CPI and PCE between June and July. The peak for Core CPI was set back in March 2022. The prices of things other than the food/energy affected by the Ukraine war has been increasing at a lower pace since then. That said, there is no guarantee commodities won't go right back up. It seems to me like Siegel is suggesting the FOMC hold off on rate hikes in the hopes that commodities keep falling, which would put them in a hugely vulnerable position if commodities went back up instead. I suspect the FOMC would rather keep hitting inflation until they are sure it's dead, rather than making Arthur Burns-esque excuses each quarter for various transitory idiosyncrasies being responsible for inflation. 

[ChpBstrd]

Prediction / Embarrassment Time!

August CPI will be 8.5% higher than a year ago. PPI will be 15.5% higher YoY.

August CPI will be reported on 9/13. Here are the inputs into my intuitive model:

1) Commodities (i.e. the S&P GSCI index) have been mostly flat from June to July. This seems to have been the best predictor of inflation so far.
https://tradingeconomics.com/commodity/gsci

2) Average Hourly Wages have similarly been flat growth. June, July, and August wages have all been about 5.2% higher than a year before.


3) Inventories: The most recent data were from June (reported Aug 17) but so far the pace of inventory accumulation is accelerating as companies try to buy ahead of expected price hikes.


4) Savings Rate: This was 5.0% in both June and July (last reported 8/26). By all signs consumers are plowing their full-employment earnings into buying more and more of that inventory that is accumulating at a fast pace. They too are trying to buy goods and especially services ahead of price hikes.


5) Money Supply (M2) was barely higher in July than in June. Add this to our list of stable metrics. I wish velocity was reported more often than quarterly, but I guess we'll have to wait for dollar digitization for that to occur.


6) Calendar Effects: The August 2022 CPI will be compared against the August 2021 CPI of 273.092 (on FRED's standard indexing of 1982=100). Between July 2021 and August 2021, CPI only increased below trend at 0.33%. This is part of why people - myself included - thought inflation was transitory in the fall of 2021. Reality didn't set in until November 2021. But it also means we might see a bigger YoY increase between the two Augusts than we saw between the two Julys. This argues in favor of a higher annualized number regardless of the monthly increase.


7) Recession indicators other than the yield curve are saying "no recession". The NFCI shows continuing easing of financing. Employment levels continue to rise. The bleep in the unemployment rate in August was due to a sudden uptick in people entering the labor force (perhaps drawn back by higher wages?). Despite the media hype, layoffs remain low. Overall the picture is absolutely not disinflationary.






8) Manufacturing Metrics like Durable goods orders and total new orders slowed down slightly. Markets initially rallied when the July numbers were reported today on hopes that the recession was already here, but then the rally collapsed when traders realized it was mostly the market price of petroleum output that dragged down the numbers. For many items, manufacturing was UP.




9) The GDP Now model was forecasting 2.6% GDP growth as of yesterday.
https://www.atlantafed.org/cqer/research/gdpnow

So overall, not much changed between July and August. Except for the high inflation and inverted yield curve, the economy looks healthy. It often looks healthy before a recession, but we should bear in mind we are only about 2 months past the 2/10 yield curve inversion, and the mean time to recession after such an inversion is about 18 months. It is highly unusual for a recession to occur 9 months or less after a 2/10 inversion.

I think if I'm wrong about

Your thoughts?

[wageslave23]

https://www.msn.com/en-us/money/markets/wharton-professor-jeremy-siegel-says-most-inflation-data-is-coming-in-below-expectations-and-the-feds-hawkish-outlook-is-at-odds-with-economic-reality/ar-AA11p9nf?li=BBnbfcL
This guy has a good point. Why is Powell making statements about next year? They have been consistently wrong with their predictions for the past 18 months. Just stick to the short term and try to get that right.

I think Powell had to express determination and warn of painful future rate hikes because the markets had/have an unrealistically dovish outlook. Powell is both covering himself against any accusations that higher-than expected rates were not forewarned and also actively trying to talk inflation down.

When he implies a much higher rate trajectory that involves "pain", people who were thinking about loading up on inventory, hiring more workers, or expanding their businesses take note and reduce their planned expenditures and use of debt. If they cut spending, or at least stop hoarding goods in anticipation of higher prices, aggregate demand and inflation goes down. It has been weird to see stocks and bonds tanking this week, as if people just got the memo that inflation is over 8% and lots of rate hikes beyond 4% could be coming. Do they not read the MMM Forum?!

A less benign interpretation is that Powell is hoping the FOMC can use tough language to force inflation down because (a) they don't want to raise rates 0.75% for the next 6 meetings, and (b) they cannot raise rates above inflation any time soon. We might be starting the "Whip Inflation Now" sloganeering phase. If Powell suspects, as I suspect, that policy is inflationary anytime the FFR<CPI, then he knows he is so far behind that tough talk is his only weapon to hold back inflation for the next 6-10 months until rates catch up with inflation or a recession strikes.

Regarding the claim that the July data signal the turning point for inflation, it simply looks to me like commodities speculation peaked in June and then the bubble deflated. That's all we need to know to predict a minor dip in CPI and PCE between June and July. The peak for Core CPI was set back in March 2022. The prices of things other than the food/energy affected by the Ukraine war has been increasing at a lower pace since then. That said, there is no guarantee commodities won't go right back up. It seems to me like Siegel is suggesting the FOMC hold off on rate hikes in the hopes that commodities keep falling, which would put them in a hugely vulnerable position if commodities went back up instead. I suspect the FOMC would rather keep hitting inflation until they are sure it's dead, rather than making Arthur Burns-esque excuses each quarter for various transitory idiosyncrasies being responsible for inflation.

I didn't consider that powell's tough talk is another weapon in his arsenal to cool the economy.  That makes sense. On a side note, I'm beginning to wonder, what if interest rates don't have as much of an effect on inflation as everyone seems to think they do. I.e what if inflation is going to run its course regardless of whether rates are 2% or 7%?

Also, if a recession is desired in order to kill inflation, wouldn't it be easier to just raise rates by 2% in September? I feel like that would have more of an impact than .75 and then .50, .50, .25.  It's not like these rates are set in stone. Once the recession is obvious, you can always cut rates. I'm trying to think of an analogy, maybe trying to kill an infection with too low a dose of antibiotics and you end up just producing antibiotic resistant bacteria. Or if you are trying to guess a number 1 to 100 with the least amount of too high or too low guesses, you start with 50 and then either 25 or 75 depending on if 50 was too high or low.

[ChpBstrd]

https://www.msn.com/en-us/money/markets/wharton-professor-jeremy-siegel-says-most-inflation-data-is-coming-in-below-expectations-and-the-feds-hawkish-outlook-is-at-odds-with-economic-reality/ar-AA11p9nf?li=BBnbfcL
This guy has a good point. Why is Powell making statements about next year? They have been consistently wrong with their predictions for the past 18 months. Just stick to the short term and try to get that right.

I think Powell had to express determination and warn of painful future rate hikes because the markets had/have an unrealistically dovish outlook. Powell is both covering himself against any accusations that higher-than expected rates were not forewarned and also actively trying to talk inflation down.

When he implies a much higher rate trajectory that involves "pain", people who were thinking about loading up on inventory, hiring more workers, or expanding their businesses take note and reduce their planned expenditures and use of debt. If they cut spending, or at least stop hoarding goods in anticipation of higher prices, aggregate demand and inflation goes down. It has been weird to see stocks and bonds tanking this week, as if people just got the memo that inflation is over 8% and lots of rate hikes beyond 4% could be coming. Do they not read the MMM Forum?!

A less benign interpretation is that Powell is hoping the FOMC can use tough language to force inflation down because (a) they don't want to raise rates 0.75% for the next 6 meetings, and (b) they cannot raise rates above inflation any time soon. We might be starting the "Whip Inflation Now" sloganeering phase. If Powell suspects, as I suspect, that policy is inflationary anytime the FFR<CPI, then he knows he is so far behind that tough talk is his only weapon to hold back inflation for the next 6-10 months until rates catch up with inflation or a recession strikes.

Regarding the claim that the July data signal the turning point for inflation, it simply looks to me like commodities speculation peaked in June and then the bubble deflated. That's all we need to know to predict a minor dip in CPI and PCE between June and July. The peak for Core CPI was set back in March 2022. The prices of things other than the food/energy affected by the Ukraine war has been increasing at a lower pace since then. That said, there is no guarantee commodities won't go right back up. It seems to me like Siegel is suggesting the FOMC hold off on rate hikes in the hopes that commodities keep falling, which would put them in a hugely vulnerable position if commodities went back up instead. I suspect the FOMC would rather keep hitting inflation until they are sure it's dead, rather than making Arthur Burns-esque excuses each quarter for various transitory idiosyncrasies being responsible for inflation.

I didn't consider that powell's tough talk is another weapon in his arsenal to cool the economy.  That makes sense. On a side note, I'm beginning to wonder, what if interest rates don't have as much of an effect on inflation as everyone seems to think they do. I.e what if inflation is going to run its course regardless of whether rates are 2% or 7%?

Also, if a recession is desired in order to kill inflation, wouldn't it be easier to just raise rates by 2% in September? I feel like that would have more of an impact than .75 and then .50, .50, .25.  It's not like these rates are set in stone. Once the recession is obvious, you can always cut rates. I'm trying to think of an analogy, maybe trying to kill an infection with too low a dose of antibiotics and you end up just producing antibiotic resistant bacteria. Or if you are trying to guess a number 1 to 100 with the least amount of too high or too low guesses, you start with 50 and then either 25 or 75 depending on if 50 was too high or low.

There's a case to be made that 8-9% inflation is less bad than the consequences that could happen if interest rates rose too quickly for markets and banks to adapt. Consequences of a sudden rate hike might include:

• Commercial banks take our on-demand deposits and invest them in longer-duration bonds, particularly treasuries. Such bonds would rapidly lose value if rates were suddenly hiked. This means that in the event of a bank run, the banks would not be able to liquidate their bonds for the full amount investors demand. Or governments might force them to post more reserves. This cuts their ability to make loans, which cuts economic growth.
• Insurance companies invest their customers' premiums in the sorts of assets that would rapidly decline if the discount rate rose too fast. A bad hurricane season or a California earthquake, combined with the rapid sequence of rate hikes, could leave such companies insolvent and unable to pay claims... or repay banks and investors.
• If the U.S. hiked its rates very high - say a 7% FFR - but other banks such as the EU, the Japanese, the British, Australia, Canada, etc. did NOT raise their rates as quickly, there the value of the dollar would increase rapidly compared to these currencies. That would be bad for US exporters and foreign borrowers who sold dollar bonds. A worldwide financial crisis could be a result of emerging countries' financial collapse. A collapse in US exports would be bad for the economy too.
• Investment banks seem to be fond of selling derivatives against unimaginable events, which works well until it doesn't. If interest rates and forex rates changed too fast, it seems almost certain that some US or foreign investment bank would be caught with the toxic and explosive equivalent of credit default swaps in 2008. We have been assured things are more tightly regulated now, but I'll believe that when for the first time in my adult life I see a sudden asset devaluation NOT cause an investment banking crisis. This sort of risk affects the valuation of all sorts of investment assets.
• The price Americans can afford to pay for a house is very sensitive to interest rates. Here in the land of 30-year flat-rate loans, it costs $421.60/mo in P&I to borrow $100k at 3%, but that amount increases 43.2% to $599.55 at a 6% interest rate. A person who could have afforded a $100k house (using round numbers, multiply it up for realism) in the days of 3% mortgages can only afford a $70,300 house when the interest rate goes to 6%. So there is a very real risk that jacking up interest rates just a few percent could cause housing losses bigger than 2008, and another foreclosure crisis.
• Car loans are also interest rate dependent. Automakers can subsidize part of the interest rate, but the rubber hits the road when the automaker must borrow at 6-7% to subsidize loans at 0% or 1.9%. Like homes, cars get a lot less affordable when the interest rate on the loan hits 6% or 7%. Imagine the collapse of the car industry.
• A lot of corporate debt was borrowed at 2-4% and reinvested in projects with an internal rate of return in the 4-6% range. That debt has to be rolled over every few years. What happens to the corporations when the new loan rate is a couple percent higher than the IRR on the project it funds? The corporation either signs a contract to lose money for several years or it tries to sell on the marketplace the assets that only yielded 4-6%. Good luck getting your money back out of those assets!

So the FOMC is attempting to raise rates as fast as they can without causing a series of cascading failures and crises. Banks and insurance companies need to earn enough money for enough time to offset the damage rising rates have to their assets. Foreign central banks like the EU need time to raise rates in synchrony with the FOMC or else their currencies will lose value. Emerging markets need to do something to hedge or exit their dollar bond exposure. Markets for houses and cars need to adapt their products or let their real prices fall over a long period of time if demand destruction is not to occur. Corporations need time to wind down their low-yielding projects and reduce leverage so that they are not thrown into crisis immediately.

The more time all these entities have to adapt, the lower the risk of an acute crisis. The metric to watch might be the NFCI. The FOMC backed off of a larger rate hike in July when the NFCI was flashing the danger signal. Since then the NFCI has seen relief. For all these reasons, the FOMC might be thinking long term about a couple years of 0.5% and 0.25% hikes rather than a more abrupt shock to the system.

This thread of thought makes me wonder if I need to adjust my expectations of 0.75% hikes through the end of the year, and tone that down to 0.5% hikes at every meeting until 2024 or a recession, whichever occurs first. If the FOMC is aiming for a mild recession instead of a financial crisis, that's probably what they have to do. But it also means the market is very, very wrong about its long-run expectations. These same risks were what the Fed was worrying about in the 1970s after all!

[wageslave23]

https://www.msn.com/en-us/money/markets/wharton-professor-jeremy-siegel-says-most-inflation-data-is-coming-in-below-expectations-and-the-feds-hawkish-outlook-is-at-odds-with-economic-reality/ar-AA11p9nf?li=BBnbfcL
This guy has a good point. Why is Powell making statements about next year? They have been consistently wrong with their predictions for the past 18 months. Just stick to the short term and try to get that right.

I think Powell had to express determination and warn of painful future rate hikes because the markets had/have an unrealistically dovish outlook. Powell is both covering himself against any accusations that higher-than expected rates were not forewarned and also actively trying to talk inflation down.

When he implies a much higher rate trajectory that involves "pain", people who were thinking about loading up on inventory, hiring more workers, or expanding their businesses take note and reduce their planned expenditures and use of debt. If they cut spending, or at least stop hoarding goods in anticipation of higher prices, aggregate demand and inflation goes down. It has been weird to see stocks and bonds tanking this week, as if people just got the memo that inflation is over 8% and lots of rate hikes beyond 4% could be coming. Do they not read the MMM Forum?!

A less benign interpretation is that Powell is hoping the FOMC can use tough language to force inflation down because (a) they don't want to raise rates 0.75% for the next 6 meetings, and (b) they cannot raise rates above inflation any time soon. We might be starting the "Whip Inflation Now" sloganeering phase. If Powell suspects, as I suspect, that policy is inflationary anytime the FFR<CPI, then he knows he is so far behind that tough talk is his only weapon to hold back inflation for the next 6-10 months until rates catch up with inflation or a recession strikes.

Regarding the claim that the July data signal the turning point for inflation, it simply looks to me like commodities speculation peaked in June and then the bubble deflated. That's all we need to know to predict a minor dip in CPI and PCE between June and July. The peak for Core CPI was set back in March 2022. The prices of things other than the food/energy affected by the Ukraine war has been increasing at a lower pace since then. That said, there is no guarantee commodities won't go right back up. It seems to me like Siegel is suggesting the FOMC hold off on rate hikes in the hopes that commodities keep falling, which would put them in a hugely vulnerable position if commodities went back up instead. I suspect the FOMC would rather keep hitting inflation until they are sure it's dead, rather than making Arthur Burns-esque excuses each quarter for various transitory idiosyncrasies being responsible for inflation.

I didn't consider that powell's tough talk is another weapon in his arsenal to cool the economy.  That makes sense. On a side note, I'm beginning to wonder, what if interest rates don't have as much of an effect on inflation as everyone seems to think they do. I.e what if inflation is going to run its course regardless of whether rates are 2% or 7%?

Also, if a recession is desired in order to kill inflation, wouldn't it be easier to just raise rates by 2% in September? I feel like that would have more of an impact than .75 and then .50, .50, .25.  It's not like these rates are set in stone. Once the recession is obvious, you can always cut rates. I'm trying to think of an analogy, maybe trying to kill an infection with too low a dose of antibiotics and you end up just producing antibiotic resistant bacteria. Or if you are trying to guess a number 1 to 100 with the least amount of too high or too low guesses, you start with 50 and then either 25 or 75 depending on if 50 was too high or low.

There's a case to be made that 8-9% inflation is less bad than the consequences that could happen if interest rates rose too quickly for markets and banks to adapt. Consequences of a sudden rate hike might include:

• Commercial banks take our on-demand deposits and invest them in longer-duration bonds, particularly treasuries. Such bonds would rapidly lose value if rates were suddenly hiked. This means that in the event of a bank run, the banks would not be able to liquidate their bonds for the full amount investors demand. Or governments might force them to post more reserves. This cuts their ability to make loans, which cuts economic growth.
• Insurance companies invest their customers' premiums in the sorts of assets that would rapidly decline if the discount rate rose too fast. A bad hurricane season or a California earthquake, combined with the rapid sequence of rate hikes, could leave such companies insolvent and unable to pay claims... or repay banks and investors.
• If the U.S. hiked its rates very high - say a 7% FFR - but other banks such as the EU, the Japanese, the British, Australia, Canada, etc. did NOT raise their rates as quickly, there the value of the dollar would increase rapidly compared to these currencies. That would be bad for US exporters and foreign borrowers who sold dollar bonds. A worldwide financial crisis could be a result of emerging countries' financial collapse. A collapse in US exports would be bad for the economy too.
• Investment banks seem to be fond of selling derivatives against unimaginable events, which works well until it doesn't. If interest rates and forex rates changed too fast, it seems almost certain that some US or foreign investment bank would be caught with the toxic and explosive equivalent of credit default swaps in 2008. We have been assured things are more tightly regulated now, but I'll believe that when for the first time in my adult life I see a sudden asset devaluation NOT cause an investment banking crisis. This sort of risk affects the valuation of all sorts of investment assets.
• The price Americans can afford to pay for a house is very sensitive to interest rates. Here in the land of 30-year flat-rate loans, it costs $421.60/mo in P&I to borrow $100k at 3%, but that amount increases 43.2% to $599.55 at a 6% interest rate. A person who could have afforded a $100k house (using round numbers, multiply it up for realism) in the days of 3% mortgages can only afford a $70,300 house when the interest rate goes to 6%. So there is a very real risk that jacking up interest rates just a few percent could cause housing losses bigger than 2008, and another foreclosure crisis.
• Car loans are also interest rate dependent. Automakers can subsidize part of the interest rate, but the rubber hits the road when the automaker must borrow at 6-7% to subsidize loans at 0% or 1.9%. Like homes, cars get a lot less affordable when the interest rate on the loan hits 6% or 7%. Imagine the collapse of the car industry.
• A lot of corporate debt was borrowed at 2-4% and reinvested in projects with an internal rate of return in the 4-6% range. That debt has to be rolled over every few years. What happens to the corporations when the new loan rate is a couple percent higher than the IRR on the project it funds? The corporation either signs a contract to lose money for several years or it tries to sell on the marketplace the assets that only yielded 4-6%. Good luck getting your money back out of those assets!

So the FOMC is attempting to raise rates as fast as they can without causing a series of cascading failures and crises. Banks and insurance companies need to earn enough money for enough time to offset the damage rising rates have to their assets. Foreign central banks like the EU need time to raise rates in synchrony with the FOMC or else their currencies will lose value. Emerging markets need to do something to hedge or exit their dollar bond exposure. Markets for houses and cars need to adapt their products or let their real prices fall over a long period of time if demand destruction is not to occur. Corporations need time to wind down their low-yielding projects and reduce leverage so that they are not thrown into crisis immediately.

The more time all these entities have to adapt, the lower the risk of an acute crisis. The metric to watch might be the NFCI. The FOMC backed off of a larger rate hike in July when the NFCI was flashing the danger signal. Since then the NFCI has seen relief. For all these reasons, the FOMC might be thinking long term about a couple years of 0.5% and 0.25% hikes rather than a more abrupt shock to the system.

This thread of thought makes me wonder if I need to adjust my expectations of 0.75% hikes through the end of the year, and tone that down to 0.5% hikes at every meeting until 2024 or a recession, whichever occurs first. If the FOMC is aiming for a mild recession instead of a financial crisis, that's probably what they have to do. But it also means the market is very, very wrong about its long-run expectations. These same risks were what the Fed was worrying about in the 1970s after all!

Thanks for the well thought out analysis!

[ChpBstrd]

I took a deeper dive into commodities prices, which are one of the main inputs into my so-far-intuitive inflation model. I want to think about the magnitude of changes to commodities prices vs. the movement in CPI. The chart at the bottom shows the trend of the average daily price for the S&P GSCI commodities index. As you can see, the index peaked in June and has been falling ever since. The September data is only for the first two days, but continues the trend.

If we put the monthly change in the GSCI alongside the monthly change in CPI, it looks like this:

Month  Commodities      CPI
Feb     +8%                   +0.8%
Mar     +16%                 +1.24%
Apr      -1%                    +0.33%
May     +3.2%                +0.97%
Jun      +1.3%                +1.32%
Jul        -12.5%              -0.02%
Aug      -1.2%                ???

I cannot make a coherent narrative out of these data. On optimist might say look at how little CPI fell in July compared to the correction in commodities prices, and suggest that August CPI will reflect the lag. A pessimist might look at April, when commodities fell and inflation still inched up, as evidence of persistent upward price pressures or a lag in prices catching up with costs. Recall that if you chart the increase in the PPI versus the increase in the CPI, it looks as if producers have yet to pass along their price increases to consumers.



Regardless of whether the optimists or the pessimists are correct in some way, the gap between producer prices and consumer prices reflect a lot of other variables including supply shortages, employment, interest rates, and the stickiness of prices. I suspect an accurate model of inflation requires tons of variables and statistical modeling to properly weight them, which I am too lazy to do. Here are some forecasts:

https://www.forecasts.org/cpi.htm -0.39% next month
https://tradingeconomics.com/united-states/consumer-price-index-cpi?embed/forecast +0.4% by end of Q3
https://econforecasting.com/forecast-cpi +0.31% next month - I like this display because it visualizes how we are probably in for at least a couple more years of above-target inflation.

The big question now is, did the Fed's rate hikes from 0.25% to 2.5% in a matter of 5 months cause the commodities correction and the flatlining of core CPI? If so, then maybe interest rate hikes are more powerful than we give them credit for, at least in today's environment where we have a lot of business investment and returns locked in at the low rates of yesteryear. I am skeptical of such "this time is different" thinking and I suggest speculation created most of the commodities spike, and demand destruction is ending it. However, if the FOMC decides to give themselves credit, then maybe they switch to half-point hikes starting in September.

If producers have not yet fully passed on their input costs to consumers, such a conclusion would be very premature. Generally a firm's variable costs include commodities + labor. The GSCI is still up 38% YTD, average hourly wages are up 5.2%, and variable costs for each product in the CPI basket is some average of these two costs, so I can imagine firms actually cutting back on the supply of their goods if they cannot pass on their cost increases to consumers, especially if margins go below zero or the return on capital investments is less than loan rates. Supply reductions such as these would exacerbate supply/demand imbalances in an inflationary way.

An architect told me that storefront-style glass windows now cost $400/square foot to build, compared to $40 in typical times. Yet, there is construction all around. Projects that were financed at low, low rates in early 2021 are just now in progress, and blowing their budgets. That can't continue. Some of these project don't make sense now, much less projects that are in the planning phase now. When we look at real residential investment, we can see similar demand destruction in the charts:
https://fred.stlouisfed.org/series/PRFIC1
Yet, everywhere I look stores and restaurants are FULL. I suspect full employment is keeping retailers and restaurants busy, even while higher rates and commodities costs are knocking down capital projects and business expansions. At some point, weakness in construction and business expansion projects will catch up with the unemployment numbers, but until then the service industry might start cannibalizing construction and tech/ad industry jobs.

[Mr. Green]

@ChpBstrd I think the "experts" seriously underestimated how much demand has outstripped supply over the last 12-18 months. That's my reasoning for why the Fed actions have not yet caught up to the average consumer. I do think there is some lag in the impact but I also think we are still working our way back to normal demand levels. I can't help but wonder if collapsing commodity prices trending back toward normal will inevitably create a floor in any recessionary movement because the cheaper things get, the more appealing spending will look to everyone still with means. Perhaps we never really see a true recession from the consumer's perspective, with the exception of maybe housing related jobs where whiplash is widely expected after the insanity of the last two years.

[ChpBstrd]

@ChpBstrd I think the "experts" seriously underestimated how much demand has outstripped supply over the last 12-18 months. That's my reasoning for why the Fed actions have not yet caught up to the average consumer. I do think there is some lag in the impact but I also think we are still working our way back to normal demand levels. I can't help but wonder if collapsing commodity prices trending back toward normal will inevitably create a floor in any recessionary movement because the cheaper things get, the more appealing spending will look to everyone still with means. Perhaps we never really see a true recession from the consumer's perspective, with the exception of maybe housing related jobs where whiplash is widely expected after the insanity of the last two years.

I agree that lower commodity prices are stimulative. Indices are now back to levels last seen on March 1, right after Putin's invasion of Ukraine. Crude oil and gasoline have fallen back to January levels. The London Metals Exchange index is back to February 2021 levels. Lumber and copper are closing in on their historically typical ranges and steel is already there. Thermal fuels like coal and natural gas appear to be the main exceptions to the commodities rout.

We have to think about being in a "neutral" commodities environment - with full employment - and with the FFR well below the rate of inflation. Falling commodities might partially offset the effects of higher interest rates and inflation on consumption. I suspect there are also lots of "sticky" prices that are being raised at a delayed rate. Car makers, for example, settled on MSRPs for their 2022 models late last year, and will set their prices for 2023 models soon. Restaurants have to reprint menus and retail stores have to re-label everything. Services like colleges, warranties, insurers, etc. typically have their prices locked in 6 months to a year before the service is consumed. Many companies have their prices locked by firm fixed price contracts that don't expire for years. Until those price hikes actually arrive, I don't think they'll be counted in CPI.

So I'm counting up a lot of pro-inflationary effects on the one hand, and commodities and interest rates on the other.

[ChpBstrd]

I found an interesting article where former trader Joseph Wang is interviewed on the question of why the Fed isn't leaning harder on QT:
https://www.barrons.com/articles/federal-reserve-quantitative-tightening-stock-market-51662736146?mod=hp_LEADSUPP_2?mod=article_signInButton

Selected quotes:

if [treasury] issuance is growing by a trillion dollars a year, it’s hard to say that there will ever be enough marginal buyers. We are locked in a world where there will always be QE, because the Fed will have to ultimately become the buyer again. The growth in Treasury issuance is faster than the market can handle by itself.

Consider that over the past 20 years, the amount of Treasuries outstanding has more than tripled, but the average daily volume in the cash market has grown far slower. That is inherently unstable.

Where liquidity comes out is also beyond the Fed’s control. When the Treasury issues new securities, they can either be purchased by cash investors, like banks, or levered investors, like hedge funds. When they’re purchased by levered investors, the money that goes to fund them most likely comes out of the Fed’s reverse repo facility, or RRP, an overnight lending program that you can think of as excess liquidity in the financial system.

If the newly issued Treasuries are purchased by levered investors, that results in draining liquidity that the financial system doesn’t really need, so the impact is neutral. But if the newly issued securities are purchased by cash investors, someone is taking money out of the bank and using it to purchase Treasuries to repay the Fed. In that case the banking sector loses liquidity, which can be disruptive, because it’s possible that someone, somewhere is dependent on that liquidity. That is what happened in September 2019 when the repo market seized up and the Fed had to add more reserves.

The Fed thinks of QT as being limited by how much liquidity the banks need to operate well. They feel that the balance sheet could drop by around $2.5 trillion, and it would be fine. But remember, the Fed doesn’t have a lot of control over how the liquidity is drained. It seems they want the banking sector to have above $2 trillion in reserves. Right now, the banking sector has about $3 trillion. The only way QT can proceed as currently forecast is to ensure that the liquidity is drawn more evenly out of the financial system—meaning more liquidity coming out of the RPP versus the banking sector. If the Fed can’t find a way to achieve that balance, it might have to stop early.

Synopsis:

• QT could cause issues with bank liquidity, and is limited by how many assets the banks can absorb, especially long-duration assets.
• When hedge funds borrow from the overnight repo markets to buy and hold treasuries, that doesn't reduce money supply.
• Wang thinks the treasury market is becoming illiquid, which contradicts most of what I've learned over the years.
• Wang suggests using the Treasury as a QT pass-through to avoid stressing the banks, and to exchange short-duration assets for long-duration.

Overall, the article left me with a bearish impression. If I'm wrong about the FFR going above 5%, then maybe Wang will be right about another credit seizure happening. There's a lot that could break as banks' assets get squeezed from rising rates and QT at the same time, and some markets might be less robust than I had assumed. In any case, there is near-zero hope for accelerated QT as a way to knock out inflation while not raising rates too high. There are simply too many voices from the Fed orbit calling it impossible.

In addition, I can imagine an "upward spiral" scenario in which destabilization leads to increased demand for treasuries, which leads to falling long term yields, which leads to deeper and deeper yield curve inversions, which leads to more destabilization (such as banks being unable to lend), which drives even more demand for treasuries...

[ChpBstrd]

I'm going to revise down my 9/2/22 estimate and say CPI will rise 8.2% and PPI will be 13%.

I'll letting the professional economists drag me down here:

Traders of derivatives-like instruments known as fixings now expect August’s annual headline inflation rate to be 8.1%, down from 8.5% in July. They also see the rate gradually declining to 7.7% for September, 6.9% for October, almost 6.4% for November, and 6.1% for December.

https://www.marketwatch.com/story/traders-see-inflation-falling-for-rest-of-2022-but-that-likely-wont-end-fed-rate-hikes-or-market-volatility-11662996756?mod=home-page

So a model combining these professional forecasts plus my *most dovish imaginable* expectations for rate hikes would look something like this:

Date           Forecast CPI            FFR upper range (my forecast)
Aug'22            8.1%                      2.5% (final)
Sept '22          7.7%                      3.25% (+.75%)
Oct'22             6.9%                      3.25% (no meeting in Oct)
Nov'22            6.4%                      3.75% (+.5%)
Dec'22            6.1%                      4.25% (+.5%)
Jan'23             ???                         4.25%
Feb'23             ???                         4.5% (+.25%)
Mar'23             ???                         4.75% (+.25%)

[EscapeVelocity2020]

So a model combining these professional forecasts plus my *most dovish imaginable* expectations for rate hikes would look something like this:

Date           Forecast CPI            FFR upper range (my forecast)
Aug'22            8.1%                      2.5% (final)
Sept '22          7.7%                      3.25% (+.75%)
Oct'22             6.9%                      3.25% (no meeting in Oct)
Nov'22            6.4%                      3.75% (+.5%)
Dec'22            6.1%                      4.25% (+.5%)
Jan'23             ???                         4.25%
Feb'23             ???                         4.5% (+.25%)
Mar'23             ???                         4.75% (+.25%)

First off, that means that by the end of September we will still have around 8% inflation and a FFR of 300-325 (assuming 75 bp).  Are we really supposed to believe that the Fed is 'pulling out all the stops' to bring inflation back to a 2% target?

Also, with commodities flaring back up, rent and housing prices remaining sticky, PPI increasing, and China Covid lockdowns... I think forecast CPI is too low headed in to the hot consumer-centric end of the year.  I guess time will tell, but the stock market is pricing in a pushover Fed which, ironically, is making the Fed have to fight inflation more aggressively.  In a perfect world, the market would react to strong words from the Fed and make their job easier, but the Fed is less credible when they remain clearly behind the curve and seemingly unable to do much about it.  The August 25th Jackson Hole rhetoric has already lost its bite, so I won't be surprised if the Fed isn't forced in to another 75 bp by stubbornly high inflation in October and November.

[ChpBstrd]

First off, that means that by the end of September we will still have around 8% inflation and a FFR of 300-325 (assuming 75 bp).  Are we really supposed to believe that the Fed is 'pulling out all the stops' to bring inflation back to a 2% target?

Also, with commodities flaring back up, rent and housing prices remaining sticky, PPI increasing, and China Covid lockdowns... I think forecast CPI is too low headed in to the hot consumer-centric end of the year.  I guess time will tell, but the stock market is pricing in a pushover Fed which, ironically, is making the Fed have to fight inflation more aggressively.  In a perfect world, the market would react to strong words from the Fed and make their job easier, but the Fed is less credible when they remain clearly behind the curve and seemingly unable to do much about it.  The August 25th Jackson Hole rhetoric has already lost its bite, so I won't be surprised if the Fed isn't forced in to another 75 bp by stubbornly high inflation in October and November.

I think your perspective is looking more correct @EscapeVelocity2020 . CPI came in at 8.3% and Core CPI rose to 6.3%. These results mean the current rate hikes and QT have been insufficient.
https://www.bls.gov/cpi/latest-numbers.htm

These results could be summarized as "CPI moderated less than expected in response to lower commodities prices, but a still-rising Core CPI revealed the rate hikes and QT we've seen so far have done little to impact inflation." The CME futures market has, in one day, reduced the 9% odds of a 50 basis point hike to zero, and changed the odds of a 100 basis point hike from zero to 18%! The futures market also notably started to factor in a tiny 4% chance of the FFR hitting 5% by May. They're slooooowwwly catching on.
https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

My Conclusions:

• July's fall in CPI was, in hindsight, only noise from the commodities market.
• Efforts so far to reverse the trend of >8% inflation have been too little, too late. The Fed is in a race against expectations setting in.
• A fast 5-month series of FFR hikes from 0.25% to 2.5% was insufficient to put a dent in the inflation trend. Still, the next 5 months might only deliver another 2.5% in rate hikes.
• The assumptions of the Taylor Rule remain un-rebunked! The FFR may have to exceed core inflation to get us back to 2%.
• The S&P 500's PE ratio could fall to the mid-teens by next summer, and SWR's could rise above 5% by then.
• The rationale to own stocks right now is the assumption that the Fed lacks credibility, and will be doing only a couple more small rate hikes because inflation will resolve on its own. That assumption just took a big hit. 
• The Fed is out of good options: They can only hike rates until something breaks OR lose credibility and re-do the 1970s.

[PDXTabs]

The Fed is out of good options: They can only hike rates until something breaks OR lose credibility and re-do the 1970s.

I trust them to keep hiking. I think they'll break things before they repeat the 1970s.

If only Bernanke would deliver a 1% rate hike while smoking a cigar.

[dividendman]

Isn't there some lag between rate increases and actual impacts to the economy/inflation? The Fed has only been increasing rates for what... about half a year? I tried googling it but couldn't figure out the lag... I guess it's a complicated problem.

Anecdotally I was talking to several of my neighbors who were planning on moving into larger houses now all backing out due to the rates. One of them actually sold their current home a while back, they were renting it back from the new owners, and now can't afford the mortgage on the new build they put a deposit on!

So... to me, it seems like we're just starting to see some real impacts of higher rates.

[EscapeVelocity2020]

First off, that means that by the end of September we will still have around 8% inflation and a FFR of 300-325 (assuming 75 bp).  Are we really supposed to believe that the Fed is 'pulling out all the stops' to bring inflation back to a 2% target?

Also, with commodities flaring back up, rent and housing prices remaining sticky, PPI increasing, and China Covid lockdowns... I think forecast CPI is too low headed in to the hot consumer-centric end of the year.  I guess time will tell, but the stock market is pricing in a pushover Fed which, ironically, is making the Fed have to fight inflation more aggressively.  In a perfect world, the market would react to strong words from the Fed and make their job easier, but the Fed is less credible when they remain clearly behind the curve and seemingly unable to do much about it.  The August 25th Jackson Hole rhetoric has already lost its bite, so I won't be surprised if the Fed isn't forced in to another 75 bp by stubbornly high inflation in October and November.

I think your perspective is looking more correct @EscapeVelocity2020 . CPI came in at 8.3% and Core CPI rose to 6.3%. These results mean the current rate hikes and QT have been insufficient.
https://www.bls.gov/cpi/latest-numbers.htm
...

WooHoo!  NGL, I'm unnerved by the Wall St. experts being so wrong about the CPI reading this morning.  With the strong, sustained rally going in to the release, I was reassured that CPI numbers had either been leaked or estimated by outside professionals...  Right now traders can't seem to de-risk fast enough...  I'm still operating on a theory that the QE and international money is desperately trying to find a home with global inflation eating up purchasing power, so where does it go when the Fed looks like they need to derail the equities party by any means necessary?  Rich people really don't mind inflation, they can afford it and have assets that preserve their wealth, but their discretionary dollars still need somewhere to go...

So yeah, we probably never would have had inflation if QE had been more restrained and, if your earlier QT analysis is correct, the Fed is going to have a nightmare implementing QT... 

[ChpBstrd]

Months ago, I said that this summer would provide the information we need to decide whether inflation will come down quickly or if we're in for a long haul.

The transitory scenario seems like the only one with the potential for a positive stock market outcome, such as would occur if earnings growth and a rapid decline of the inflation rate both overwhelmed the effect of higher rates or reduced everyone's expectations for future rate hikes. Markets had a little rally in March when the inflation trajectory seemed to be flattening, because if inflation started going down then the Fed might not end up hiking much after all. We will know by THIS SUMMER if the transitory scenario is happening.

If the CPI/PCE numbers this summer show a rapid decline in inflation, my narrative will be that stimulus money and QE caused the inflation, and the inflation is going away in their absence. If the inflation numbers are persistently high though, my narrative will be that rates are going higher than the 3-4% that bond markets are predicting.

Well, the summer results are IN! When we look at the 3 scenarios I initially proposed, the results are a mixed bag. Green=occurred, Red=did not occur:

a) Severe Recession
     i) Signals:
          -sudden reversal in commodities index
          -sudden increase in inventories
          -sustained yield curve inversion: 10/2s or 10/3mo
          -rapid fall in inflation, accompanied by continued Fed rate hikes OR...
          -continued increases in inflation into the 7-10% range.
          -asset price meltdowns (housing and mortgages, growth stocks, financial institutions)
     ii) Most likely outcome:
          -25-30% drop in S&P 500 from here (not unusual in recessions) within the next 2y.
               *A S&P500 P/E ratio in the mid-teens is historically fair for environments where 10y treasuries yield 3.5%.
               *The earnings yield (E/P) is currently (1/21=) 4.76% which is not high enough if treasuries are heading to >4%!
               *Market over-reactions during recessions can push valuations far lower than a "fair" equity risk premium suggests.
               *Buy signal: S&P500 ttm PE ratio hits 15-17.
               *In the height of the panic, safer assets such as preferred stocks can yield 7.5%+.
                    -This could represent a retirement lock-in opportunity at >4% WRs, as it was in 2020.
          -bonds may drop until the recession is widely expected, at which point they could rally.
     iii) Winning strategy
          -stay in cash until you can pick up preferreds and corporate bonds at yields equaling WR + a modest inflation estimate.
          -pivot into a stock-heavy portfolio at a point of very high pessimism.
     iv) Historical parallel
          -1999-2003
          -2004-2007

b) Transitory Scenario
     i) Signals:
          a) metrics mentioned above show steady economic growth despite rate hikes
          b) a healthy yield curve
          c) a mild technical recession could still occur, but against 2021 comps this isn't necessarily a bad sign.
               -consider how much the $1.9T stimulus contributed to GDP in 2021. 2022 can't match that.
          d) inflation slowly falls in summer/fall 2022 in response to higher rates and QT.
      ii) Most likely outcome:
           a) 1-10% growth for the S&P500.
           b) modest bond losses
      iii) Winning strategy:
           a) Buy and hold a stock-heavy portfolio or rebalance through the volatility.
      iv) Historical parallels:
           a) 2018
           b) 2012-2013
           c) 1993-1994

c) Fed Overreaction
     i) Signals:
          a) Fed minutes utterly discount the possibility of falling inflation and employment
          b) Fed minutes suggest the inverse of "letting inflation run hot for a while" as they said in 2020.
          c) Continued rate hikes through late 2022 despite inflation falling to the 2-4% range or lower.
          d) Escalating rate hike expectations... 4%... 5%... 6%...7%!
     ii) Most likely outcome:
          a) Rate hikes drive the 10y yield to 5-6% even as inflation falls.
          b) S&P500 PE ratio goes into the low teens. 30%+ correction.
     iii) Winning strategy:
          a) Sit in cash or hedged positions for at least a year, maybe up to 2.
          b) Buy when S&P500 valuations are about a third lower than they are currently.
     iv) Historical parallel:
          a) arguably most recessions for the past several decades:

Time to call it; I think the majority of the evidence points to scenario 1 - severe recession.

In fact, some might say I'm being too harsh in denying that asset price meltdowns occurred - but housing and stocks have barely taken a dent since May, and there is no sign of bank distress so far. The NFCI is hovering dangerously close to zero, so maybe bank distress is a "not yet" item. WRT the "rapidly fall in inflation" OR "continued increases in inflation into the 7-10% range" I think that latter has occurred and the former will eventually occur. The rapid fall in inflation will be the recession start signal at a future time, and the rest of the expectations around this scenario predict it.

I'm putting my money where my analysis is with the following trades today:

Bear put spread on SPY (currently $398.63)
     -300 Sept 16 408 put
     +300 Sept 16 409 put
     Previous episodes of bad inflation news were followed by flat-to-down days. This play will hopefully pick up over 12.3% in 3 days.

Buy 5k shares of SPDN @ $16.21
     This is in addition to 2k shares I already own in this 1x bear fund with a 0.5% ER.

Sell puts on SQQQ (currently $45.73)
     -32 Sept 16 $43.50 strike @ $1.20
     This play is already up $1400 for the day, but I'll be greedy and hold this volatile position until Friday.

Buy call options on SPDN (currently $16.20)
     +50 Apr 21, 2023 $14 strike @ $2.60
     Not yet executed. The cost of that time value - less than 2.5% of current price - is acceptable in exchange for 7x leverage and limited downside.

This gets me out of a mostly-cash position and into a bearish posture. I still have cash to deploy, but can wait for the inevitable bounce-back :)

[Kevin Aster Tin Obin]

Just caught up on the last page of this thread and was going to ask the question "so what"?  ..appreciated chpbstrd saying what trades he was executing. Curious if folks are doing all this analysis for short term (1-2 year ) beta to beat the market with a small % of assets, or adjusting all your investable assets to increase ROI to get to fire sooner, or maybe something else?  Trying to gauge if these moves are worth doing in 401k or just investable accounts or maybe even leverage real estate and buy options with low interest debt cash.

[Radagast]

Not related to inflation and interests, but for general economic indicators I notice that RZV is perhaps the most prescient ticker. The problem is that it's so noisy that's it's probably impossible to tell except in hindsight, but invariably you will look back and notice RZV began to plummet at the first sign of trouble.

Question: what would happen if the Fed just matched it's rate to inflation? It seems that in all past cases simply setting the Fed rate to match inflation would have reacted quicker to both inflation and deflation, and in a more neutral and predictable way. Or at least inflation could be the default instead of a meaningless 0, and they could set their rate + or - relative to that.

[MustacheAndaHalf]

ChpBstrd - You listed your actions, but not the premiums involved for them.  This is from your Sept 13 post:

I'm putting my money where my analysis is with the following trades today:

Bear put spread on SPY (currently $398.63)
     -300 Sept 16 408 put
     +300 Sept 16 409 put
     Previous episodes of bad inflation news were followed by flat-to-down days. This play will hopefully pick up over 12.3% in 3 days.

Buy 5k shares of SPDN @ $16.21
     This is in addition to 2k shares I already own in this 1x bear fund with a 0.5% ER.

Sell puts on SQQQ (currently $45.73)
     -32 Sept 16 $43.50 strike @ $1.20
     This play is already up $1400 for the day, but I'll be greedy and hold this volatile position until Friday.

I see advantages of SPXU over SPDN, the first being a $2k investment is equal to a $6k investment (for ease of math, I'm not using $5k):
$2000 SPXU x 0.90% expense ratio = $18/year, but acts like $6k S&P 500
$6000 SPDN x 0.49% expense ratio = $28.40/year, requiring using $4k more cash
Over long periods of high volatility, SPXU can lose more than SPDN.  But for a one week investment I think there's little risk of that.

What went into picking the $408 / $409 bear put spread?
I tend to look at longer term put spreads, so I've never seen a profitable $1 spread like this (but it's often in individual stocks, and months away - very different from the highly liquid S&P 500 later the same week)

In June, I bought VIX call options expiring a week later, and those made a multiple of my investment.  I see VIX was $23 on Sept 9 (Fri), and closed at $26 on Sept 14 (Wed), with some spikes in the $27 range the day CPI-U was released.  Actually I might have been viewing VIX investing incorrectly, as +200% sometimes and -100% usually.  When the VIX doesn't change much, it's roughly breakeven... an expected CPI print.  when the VIX spikes, it's profitable.  (This only works because of how closely the markets follow inflation - once that goes away, so does this approach).

[wageslave23]

Not related to inflation and interests, but for general economic indicators I notice that RZV is perhaps the most prescient ticker. The problem is that it's so noisy that's it's probably impossible to tell except in hindsight, but invariably you will look back and notice RZV began to plummet at the first sign of trouble.

Question: what would happen if the Fed just matched it's rate to inflation? It seems that in all past cases simply setting the Fed rate to match inflation would have reacted quicker to both inflation and deflation, and in a more neutral and predictable way. Or at least inflation could be the default instead of a meaningless 0, and they could set their rate + or - relative to that.

The problem is the inflation rate either is calculated using inflation data that is 11 months old (increase in prices from 12 months ago) or is far too volatile (annualizing monthly inflation data).  Or the Fed could just grow a pair and change rates more quickly.

[ChpBstrd]

Question: what would happen if the Fed just matched it's rate to inflation? It seems that in all past cases simply setting the Fed rate to match inflation would have reacted quicker to both inflation and deflation, and in a more neutral and predictable way. Or at least inflation could be the default instead of a meaningless 0, and they could set their rate + or - relative to that.

This is a terrifying thought experiment, but it actually jives with what the Federal Reserve says to do on their website! https://www.federalreserve.gov/monetarypolicy/principles-for-the-conduct-of-monetary-policy.htm

If the FOMC announced next week that the rate for overnight loans was going from 2.5% to 8%, there would be a rush out of stocks, bonds, real estate, etc. People would try to liquidate everything to chase those 8% risk-free rates, and to liquidate before other people liquidated. Loan collateral such as bonds or real assets would vaporize, and bank runs could occur. Companies would lay off workers because the ROI from the workers' salaries is less than the ROI from short-term treasuries, and because people aren't buying anything when credit is so expensive. Mortgages and car loan rates would be 10-15% IF you could find a lender that was still solvent. In the longer run, many (most?) corporations would not be able to roll their debt forward at rates less than their return on assets. Interest costs would bankrupt lots of companies, and for others the math would favor a radical downsizing.

But forget the hypothetical narratives - try plugging in some details into these models:

1) Calculate how far a 3.5% 10 year treasury would depreciate if rates jumped to 8%:
https://www.thecalculator.co/finance/Bond-Price-Calculator-606.html
Keep in mind these are the collateral for a LOT of loans. These "safe" assets are also held on corporate balance sheets, pension funds, and insurance company reserves.

2) Calculate how far the PE ratio for the S&P500 would need to fall if rates jumped to 8%.
https://www.investopedia.com/articles/stocks/08/fed-model.asp
https://www.multpl.com/s-p-500-pe-ratio
So the current PE ratio is 19.84, an earnings yield of ~5%, which is a 1.6% risk premium over the currently 3.4% 10-year treasury. The 10-year treasury is about 0.9% above the federal funds rate. Therefore, if risk premiums stayed the same and the FFR rose to 8% next week, then the 10-year treasury bond could be expected to yield about (8 + 0.9 =) 8.9%, and the earnings yield of the S&P500 could be expected to be (8.9 + 1.6 =) 10.5%. That's a PE ratio of (1 / 10.5 =)9.5 which would require a 52% drop in valuation for the S&P500.

3) Calculate how much a house's value must fall to maintain the same payment if rates go from 4% to 11%:
https://www.calculator.net/mortgage-calculator.html
$1M loan at 4% = $4774.15 P&I payment
$1M loan at 11% = $9523.23 (a 99.5% increase in the size of the payment!)
$501,400 loan at 11% = $4774.95 (prices have to fall almost in half to maintain affordability)
You might say that people will just decide they'll buy half as much house than they could have afforded in 2021, but that just crowds the market for the cheaper houses and leaves no buyers for the bigger ones. Meanwhile, the previous buyers of cheaper houses are forced out of the market and demand evaporates. It's a mortgage crisis in the making either way.

So this explains the gradualism in raising rates. Consumers, banks, and businesses need time to adjust to the new realities. More importantly, if the Fed can engineer a recession by raising rates to, say, 4% instead of 8%, then we might escape this inflation episode with only a standard recession instead of a severe recession plus the kind of crisis described above.

[ChpBstrd]

Just caught up on the last page of this thread and was going to ask the question "so what"?  ..appreciated chpbstrd saying what trades he was executing. Curious if folks are doing all this analysis for short term (1-2 year ) beta to beat the market with a small % of assets, or adjusting all your investable assets to increase ROI to get to fire sooner, or maybe something else?  Trying to gauge if these moves are worth doing in 401k or just investable accounts or maybe even leverage real estate and buy options with low interest debt cash.

I'm actually adjusting my AA to brace for the possibility that rates have to go very high or that we have a significant recession. I plead guilty to market timing, but episodes where interest rates go from near zero to four or five percent higher without a serious recession or stock correction are... non existent AFAIK. Also, those rate hikes are being telegraphed to us by the Fed, and will only not occur if something even worse for risk assets occurs. Finally, those rate hikes still might not be enough, and rates could go higher than anyone expects.

Yes, I am aware of the wall of worry (paging @RWD for a facepunch) but the evidence seems overwhelming at the moment that we're in for either higher rates or a recession. It's hard to champion a soft landing scenario unless inflation starts behaving differently than it has so far. But that's what I started this thread for. I need the facepunches, counterarguments, counter evidence, etc.

[EscapeVelocity2020]

Just caught up on the last page of this thread and was going to ask the question "so what"?  ..appreciated chpbstrd saying what trades he was executing. Curious if folks are doing all this analysis for short term (1-2 year ) beta to beat the market with a small % of assets, or adjusting all your investable assets to increase ROI to get to fire sooner, or maybe something else?  Trying to gauge if these moves are worth doing in 401k or just investable accounts or maybe even leverage real estate and buy options with low interest debt cash.

I'm actually adjusting my AA to brace for the possibility that rates have to go very high or that we have a significant recession. I plead guilty to market timing, but episodes where interest rates go from near zero to four or five percent higher without a serious recession or stock correction are... non existent AFAIK. Also, those rate hikes are being telegraphed to us by the Fed, and will only not occur if something even worse for risk assets occurs. Finally, those rate hikes still might not be enough, and rates could go higher than anyone expects.

Yes, I am aware of the wall of worry (paging @RWD for a facepunch) but the evidence seems overwhelming at the moment that we're in for either higher rates or a recession. It's hard to champion a soft landing scenario unless inflation starts behaving differently than it has so far. But that's what I started this thread for. I need the facepunches, counterarguments, counter evidence, etc.

Same for me, I've adjusted my AA to be more conservative and am now looking for re-entry points.  People lambasting me for market timing really doesn't bother me, but I'm also doing my best not to be taken as advising anything for anyone else - what I do in my own portfolio is tailored to my situation.  I've hit FI, so missing out on gains or losing some purchasing power is not my worst outcome.  I don't post my moves in this thread, but are documented in the 'Top is In' thread and my journal.  Currently putting some of my 'cash' (money market, stable value funds) in to VDE with a $110 purchase point.  I wish I were a real estate investor (and REIT's are not a substitute), but I missed that opportunity although I knew it was juicy.  Still, quality of life is high not having to worry about anything other than my primary residence. 

Also, in general, Economics is a hobby of mine and we are living though exciting times.  It's interesting to hear other people's ideas and opinions.

[Radagast]

Question: what would happen if the Fed just matched it's rate to inflation? It seems that in all past cases simply setting the Fed rate to match inflation would have reacted quicker to both inflation and deflation, and in a more neutral and predictable way. Or at least inflation could be the default instead of a meaningless 0, and they could set their rate + or - relative to that.

This is a terrifying thought experiment, but it actually jives with what the Federal Reserve says to do on their website! https://www.federalreserve.gov/monetarypolicy/principles-for-the-conduct-of-monetary-policy.htm
[...]
So this explains the gradualism in raising rates. Consumers, banks, and businesses need time to adjust to the new realities. More importantly, if the Fed can engineer a recession by raising rates to, say, 4% instead of 8%, then we might escape this inflation episode with only a standard recession instead of a severe recession plus the kind of crisis described above.

The question isn't why don't they do that right now resulting in a 7% jump, it's why didn't they start years ago. For example, in 2020. The rate would have been 0 in the spring of 2020, and gradually ramped up to 4% by summer 2021, likely taming inflation by the end of 2021.

December 31, 2021   7.04%
November 30, 2021   6.81%
October 31, 2021   6.22%
September 30, 2021   5.39%
August 31, 2021   5.25%
July 31, 2021   5.37%
June 30, 2021   5.39%
May 31, 2021   4.99%
April 30, 2021   4.16%
March 31, 2021   2.62%
February 28, 2021   1.68%
January 31, 2021   1.40%
December 31, 2020   1.36%
November 30, 2020   1.17%
October 31, 2020   1.18%
September 30, 2020   1.37%
August 31, 2020   1.31%

[RWD]

Yes, I am aware of the wall of worry (paging @RWD for a facepunch) but the evidence seems overwhelming at the moment that we're in for either higher rates or a recession. It's hard to champion a soft landing scenario unless inflation starts behaving differently than it has so far. But that's what I started this thread for. I need the facepunches, counterarguments, counter evidence, etc.

Your asset allocation should let you sleep at night. Ideally if you wanted a variable asset allocation you would write that into your investment policy statement, clearly indicating what the trigger conditions are for going more conservative and vice versa.

[ChpBstrd]

Just caught up on the last page of this thread and was going to ask the question "so what"?  ..appreciated chpbstrd saying what trades he was executing. Curious if folks are doing all this analysis for short term (1-2 year ) beta to beat the market with a small % of assets, or adjusting all your investable assets to increase ROI to get to fire sooner, or maybe something else?  Trying to gauge if these moves are worth doing in 401k or just investable accounts or maybe even leverage real estate and buy options with low interest debt cash.

I'm actually adjusting my AA to brace for the possibility that rates have to go very high or that we have a significant recession. I plead guilty to market timing, but episodes where interest rates go from near zero to four or five percent higher without a serious recession or stock correction are... non existent AFAIK. Also, those rate hikes are being telegraphed to us by the Fed, and will only not occur if something even worse for risk assets occurs. Finally, those rate hikes still might not be enough, and rates could go higher than anyone expects.

Yes, I am aware of the wall of worry (paging @RWD for a facepunch) but the evidence seems overwhelming at the moment that we're in for either higher rates or a recession. It's hard to champion a soft landing scenario unless inflation starts behaving differently than it has so far. But that's what I started this thread for. I need the facepunches, counterarguments, counter evidence, etc.

Same for me, I've adjusted my AA to be more conservative and am now looking for re-entry points.  People lambasting me for market timing really doesn't bother me, but I'm also doing my best not to be taken as advising anything for anyone else - what I do in my own portfolio is tailored to my situation.  I've hit FI, so missing out on gains or losing some purchasing power is not my worst outcome.  I don't post my moves in this thread, but are documented in the 'Top is In' thread and my journal.  Currently putting some of my 'cash' (money market, stable value funds) in to VDE with a $110 purchase point.  I wish I were a real estate investor (and REIT's are not a substitute), but I missed that opportunity although I knew it was juicy.  Still, quality of life is high not having to worry about anything other than my primary residence. 

Also, in general, Economics is a hobby of mine and we are living though exciting times.  It's interesting to hear other people's ideas and opinions.

Yea, I am trying to use this board as a way to solve a problem of mine. That problem is certainty. Certainty will get you absolutely killed when it comes to investing, because markets create their own outcomes and oftentimes the only thing that can possibly happen is the thing nobody is expecting. This often occurs because all other possibilities have been bid up in price.

I'd really like someone to take the other side of the debate and hit me hard with facts, stats, theory, and reasoning in support of inflation rapidly declining, the FFR maxing out around 4% or below, and stocks rallying. Maybe we need to assign this position to somebody like in high school debate class, lol. Are there any volunteers to argue the proposition that inflation is transitory, that the bottom is in, or that stocks are a compelling value right now?

[ChpBstrd]

Another massive post. Sorry.

I'm sure most people have seen this, but Ray Dalio estimates that if the FFR hits 4.5%, stocks will drop 20%. This is in line with my base case for the "severe recession" scenario.
https://www.linkedin.com/pulse/starts-inflation-ray-dalio?trk=portfolio_article-card_title

4.5% is now very close to the outcome already predicted by futures on the FFR. By July, most market participants are today predicting rates at 4% or above, and about 25% are predicting above 4.5%:
https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

Dalio writes in a folksy way, and does not go into detail on how he did the math, but he appears to be thinking in terms of the Fed Model or a discounted cash flow model. Like myself, Dalio is assuming there will be some risk premium over the FFR for longer duration treasuries, riskier bonds, and especially stocks.

How rising rates influence asset prices:

Interest rates rising relative to inflation causes prices of equities, equity-like markets, and most income-producing assets to go down because of a) the negative effects it has on incomes, b) the need for asset prices to go down to provide competitive returns i.e., “the present value effect”, and c) the fact that there is less money and credit available to buy those investment assets.

Market's prediction vs. Dalio's prediction:

Right now, the markets are discounting inflation over the next 10 years of 2.6 percent in the US. My guesstimate is that it will be around 4.5 percent to 5 percent long term, barring shocks ... In the near term, I expect inflation will fall slightly as past shocks resolve for some items (e.g., energy) and then will trend back up towards 4.5 percent to 5 percent over the medium term. I won't take you through how I arrived at that estimate (which I'm very uncertain about) because that would take too long.

Dalio is willing to conservatively assume a flat yield curve months from now:

If you want to estimate the short rate, decide what you think the yield curve will look like. What's your guesstimate? Mine is that the yield curve will be relatively flat until there is an unacceptable negative effect on the economy. Given my guesstimates about inflation and real yields, I come up with between 4.5 and 6 percent in both long and short rates. However, because I think that the higher end of this range would be intolerably bad for debtors, markets, and the economy, I'm guesstimating that the Fed will be easier than that (though 4.5 percent is probably too easy).

Dalio is being very, very optimistic here for the sake of making a conservative and easy-to-defend estimate. Yield curves tend to un-invert right before the start of recessions, or during the recession.

If another un-inversion is to happen in the near future, either the Fed would have to cut short-term rates OR long term rates would have to rise. Recent Fed statements have been about the need to keep rates higher for a long period of time to ensure the inflation fire is fully extinguished - unlike what was done in the 70's. So if we disregard the possibility of any rate cuts next year no matter how bad it gets, then the long-duration end of the curve will have to rise and an un-inversion might look like a 4.5% FFR and maybe a 6% 10-year yield. Stocks then, would have an earnings yield higher than 6%, which means the PE of the S&P500 would have to be significantly less than (1/6=) 16.7. That is, at PE=16.7 you would be getting paid zero risk premium to be in stocks versus safer 10y treasuries, so you wouldn't buy or hold stocks at such a high price.

Actually, the yield curve is not even fully flat right now. The overnight rate is 2.25%-2.5%, the 1 month rate is 2.68%, and the 10y is 3.45%. The 10y/2y spread is now more inverted than anytime since right before the 2000 recession/bear market and there's nonetheless a ~1% spread between overnight and 10y rates. If both Dalio and the futures market are predicting a 4.5% FFR, they should predict at least a 5.5% 10-year yield, and that's probably an understatement.

These are more arguments in favor of the S&P500 soon having a PE ratio in the mid-teens instead of near 20.

If you factor in dramatically reduced earnings forecasts amid a recession, then the 20% drop we're talking about could become much bigger. This is the part we cannot know. Valuation metrics go out the window as soon as a recession starts, because there's no way to tell in advance how far earnings will fall, or how long they will take to recover. As earnings fall, companies look deceptively more expensive according to earnings-based metrics.

Suppose the following happens in June 2023:

FFR = 4.5%
10y yield = 5.5% (same premium as today)
S&P 500 expected earnings yield: 7% (1.5% risk premium over 10y treasury)
S&P 500 forward P/E: 14.3 (a 28.5% fall from last week's PE of 20)*
Recession starts but the market doesn't realize it yet.

*Note: Based on Yardeni's forward PE, forecasters are expecting about a ((20/16.9)-1=) 18% earnings increase in the next 12 months, assuming no recession. If, let's say, 12% of that happens before the recession, then maybe the nominal price of stocks only falls (28.5% fall in PE minus 12% increase in E =) 16.5% between now and then.

And then the following happens by December 2023:

Recession should be a headline by now
FFR = 4.5%
10y yield = 5.5%
S&P 500 forward earnings drop 30%**
S&P 500 risk premium over treasuries increases from 1.5% to 2% due to uncertainty about the depth of recession
S&P 500 expected earnings yield: 7.5% (10y yield + 2% risk premium)
S&P 500 forward PE: 1/7.5 = 13.3***

**E.g. If earnings go up 12%, then the forecast drops 30% from there, that'd be down to 78.4% of today's earnings. -30% is a guess. Compare that guess to -50.6% in 2001 or -77.5% in 2008 and it looks optimistic.

***The trailing PE ratio normally goes higher during recessions as earnings fall, but investors look beyond the recession and price a volatile series of forward estimates. So we can't just multiply this formula-driven PE by our earnings guess and arrive at a call of where the bottom will be. In general, Yardeni's data show when the S&P500 forward PE is in the low-to-mid teens, that's a good time to buy.

In the scenario described above, S&P500 forward earnings would be (ttm earnings of 203.88 * 78.4% =) 159.84, a level similar to the forward estimates in 2017 when the S&P500 was about 2700 (29% lower than today's prices, the PE was around 25, and the 10y treasury was around 2.5%). However, investors would be unwilling to buy a stock market forward earnings yield that is not significantly higher than the 10y treasury yield. Treasuries will look attractive as inflation expectations and earnings forecasts both collapse amid the recession. IG bonds yielding even more than the treasuries - perhaps 6% to 8% - might be even more attractive. What kind of WR could those kind of yields support? [wipes drool away]

[MustacheAndaHalf]

Ten year treasuries are currently yielding less than two year or six month treasuries.  That makes it an inverted yield curve, which is a strong predictor of recession.
https://www.ustreasuryyieldcurve.com/

Two weeks ago, the Atlanta Fed predicted 2.6% GDP growth for the current quarter... and now predict 0.5% GDP growth.  An unstable estimate like that probably isn't that useful, but it certainly hints at the economy nearing recession.
"Latest estimate: 0.5 percent — September 15, 2022"
https://www.atlantafed.org/cqer/research/gdpnow

After watching Wall Street Week, I decided to lookup wage growth.  It's currently at 6.7% overall, and wage growth tends to be sticky.  Larry Summers thinks the "job switcher" number is more reflective, which is at 8.4%.  Either number spells bad news for a Fed fighting inflation.
https://www.atlantafed.org/chcs/wage-growth-tracker

[ChpBstrd]

One of the big assumptions in the model I sketched above was that there will remain at least a 1% spread between the overnight FFR and the 10y treasury yield. I examined that assumption further, and found it is not supported by history. In the below graph, we can see that the overnight rate has routinely been above the 10y yield.

This ultimate yield curve inversion happened in 2006-2007, 2000, several times in the 1980's, and for prolonged periods of time in the 1970s. As with any other inversion, it signals that investors believe rates will be lower in the future.



If the FFR and the 10y yield invert again, then maybe the 10y yield doesn't rise as high as my model suggests. The 10y yield could lag the FFR by maybe 1.5% (i.e. the current 1% spread plus the 0.5% inversion seen in 2006-2007). In that case, a rise of the FFR to 4.5% could leave 10y treasuries and stock multiples about where they are today, if not lower. Presumably this is the rationale for anyone buying these assets in a rising-rates environment.

I had considered going short TLT and ZROZ for the next 6 months, but this realization about the possibility of full-curve inversions is sobering. Long-duration yields might not rise after all!

On the flipside, the dangers of going short stocks are illustrated by the huge positive returns that typically happen after yield curve inversion and prior to recession. Even though we "know" a recession is coming, and probably within the next 18 months, history still offers no clear guidance about how to position oneself.

The short stock investments I posted earlier were obviously profitable, yielding about $10,000 in 3 days in total. However, despite all my analysis I still haven't arrived at a clear path forward. If stocks tend to rally into a coming recession, and if long-duration bonds can yield less than the overnight rate right before a recession, then it is possible to be right about the recession and rate hikes, and to still lose badly.

The one thing I'm still reasonably confident about is that a 4% FFR is not going to extinguish 8% inflation. Unless the recession arrives with ahistorical quickness or another pandemic / nuclear war shuts down the economy, we're heading to >5%. But perhaps the only way to bet on that narrow conclusion is the futures market for the Federal Funds Rate. I'm not going to use instruments like futures with infinite loss potential. AA is one thing, and gambling it all is another.

Capital preservation is a possible strategy: Just wait it out until there's blood in the streets and valuations or yields clearly support a 5% or 6% WR.

[BicycleB]

The one thing I'm still reasonably confident about is that a 4% FFR is not going to extinguish 8% inflation. Unless the recession arrives with ahistorical quickness or another pandemic / nuclear war shuts down the economy, we're heading to >5%. But perhaps the only way to bet on that narrow conclusion is the futures market for the Federal Funds Rate. I'm not going to use instruments like futures with infinite loss potential. AA is one thing, and gambling it all is another.

I have some TMV, a Treasury bear ETF from Direxion. If I understand correctly, that attempts to produce negative 3x the one day variance in investment value experienced by the holders of 20 year Treasury bonds. I guess an example would be if 20 year Treasuries fall 5% in value due to a .25% rise in long term interest rates, TMV expects to rise about 15%. Would this be a safter way to bet on FFR going up than FFR futures per se?

https://www.direxion.com/product/daily-20-year-treasury-bull-bear-3x-etfs

I had imagined that the fund operators, who presumably use a variety of futures contracts to hedge their positions, would probably not miscalculate to the point of fund value reaching zero. If they did, I guess I lose the value of the investment, but the rest of my portfolio would be unaffected by TMV (though it could have suffered from factors that affect TMV). So it seems safer. Of course 20 year Treasuries still would be reflecting the gap between FFR and long term rates, so I guess it doesn't fill your specific goal anyway.

[MustacheAndaHalf]

I have some TMV, a Treasury bear ETF from Direxion. If I understand correctly, that attempts to produce negative 3x the one day variance in investment value experienced by the holders of 20 year Treasury bonds. I guess an example would be if 20 year Treasuries fall 5% in value due to a .25% rise in long term interest rates, TMV expects to rise about 15%. Would this be a safter way to bet on FFR going up than FFR futures per se?

https://www.direxion.com/product/daily-20-year-treasury-bull-bear-3x-etfs

I had imagined that the fund operators, who presumably use a variety of futures contracts to hedge their positions, would probably not miscalculate to the point of fund value reaching zero. If they did, I guess I lose the value of the investment, but the rest of my portfolio would be unaffected by TMV (though it could have suffered from factors that affect TMV). So it seems safer. Of course 20 year Treasuries still would be reflecting the gap between FFR and long term rates, so I guess it doesn't fill your specific goal anyway.

I have an allocation to TMV as well.  I wanted to know if your estimate of duration (25x) or mine (20x) was correct, and discovered the answer is neither.  TMV has a duration of 18.34, which after a -3x multiplier becomes an overall -55x the long-term interest rate.  A 0.25% rise in LT bonds becomes a +13.75% gain for TMV.
https://www.direxion.com/uploads/TMF-TMV-Fact-Sheet.pdf

Leveraged ETFs use swaps, which require payments by the ETF.  In rare cases, things can go terribly wrong and the ETF first implodes, and then closes.  There was some oil ETF that went through that during the oil glut of 2020.  It lost well over 95% of it's value, and then oil contracts went negative.  Under those conditions, the ETF couldn't continue functioning, and it liquidated.  The tiny remaining cash was sent to investors.  Another oil related ETF, GUSH, took 3x losses on the way down, then switched to 2x gains for the recovery.

The biggest risk, in my view, is what happened on March 8 2020.  If the Fed sees a crash coming (and thinks inflation will be under control),  it could drop rates to zero.  If the Fed funds falls from 3% to 0%, and long term bonds go with it, any gains are going to be wiped away from TMV.  Even worse, March 8 2020 was not a scheduled Fed meeting - they could hold an emergency meeting to wipe out TMV (effectively).

[wageslave23]

ChpBstrd, I'll take the contrarian position that 4% interest rates could lower inflation.  Inflation expectations for 1 yr from now are 5.7%. This is higher than current interest rates.  So businesses should be pulling forward purchases.  However, they should have rationally already made these purchases because the gap has only tightened over the last 6 months. Or at least going forward, these purchases should decrease. If the longer term inflation expectations are higher than current interest rates the purchases from further down the road would still be pulled forward. But the 3 yr inflation expectation is 2.7%. So I think 3% interest rate is now basically neutral. In summary my theory is that interest rates are only inflationary if the gap between short term inflation expectations and current interest rates is growing or if current interest rates are lower than medium term inflation expectations.  I have no data to back this up but the logic seems sound.

Based on current inflation expectations, rates rising to 4% would then be deflationary.

[ChpBstrd]

ChpBstrd, I'll take the contrarian position that 4% interest rates could lower inflation.  Inflation expectations for 1 yr from now are 5.7%. This is higher than current interest rates.  So businesses should be pulling forward purchases.  However, they should have rationally already made these purchases because the gap has only tightened over the last 6 months. Or at least going forward, these purchases should decrease. If the longer term inflation expectations are higher than current interest rates the purchases from further down the road would still be pulled forward. But the 3 yr inflation expectation is 2.7%. So I think 3% interest rate is now basically neutral. In summary my theory is that interest rates are only inflationary if the gap between short term inflation expectations and current interest rates is growing or if current interest rates are lower than medium term inflation expectations.  I have no data to back this up but the logic seems sound.

Based on current inflation expectations, rates rising to 4% would then be deflationary.

Your contrarian take is appreciated. It makes sense to think that as the spread between interest rates and inflation decreases, the incentive to pull ahead purchases also decreases. Maybe 6 months ago when CPI was running at 8.5% and and the FFR was 0.5%, it was a no-brainer to take out a loan or sell bonds at maybe 3-4% to buy the next year's inventory or to make infrastructure investments before the price went up. And maybe now the added risks aren't justified by the narrower spread.

However, I'm wary of:
     1) assuming that demand must exhaust itself because inventories are already high and consumers have been on a buying binge for a year and a half, OR
     2) assuming that inflation won't go up even further from here, maintaining a spread between loan rates and inflation expectations that incentivizes spending.

It is safe to assume consumer demand is insatiable, and (for the 99% of the world that are non-Mustachians) is only held back by earnings. Similarly, if there exists any incentive to hold excess inventory or pull ahead purchases, inventories and purchases will be higher than otherwise. In normal conditions, it costs more to warehouse inventories or pull ahead purchases, and so these behaviors are avoided.

You are correct that when the incentive flips, demand will plummet, and you are correct to imply that the incentive is the spread between loan rates and inflation expectations, not necessarily FFR and historical CPI. That's the much tighter spread I should be watching.

We need to model this so that we can predict the turning point. Perhaps we start with:

N=I-E-R

where...
N = incentive to hoard or pull ahead purchases (if + purchase, if - don't)
I = a typical interest rate actually available to consumers and businesses
E = inflation expectations by consumers and businesses
R = risk premium for tying up cash by pulling ahead purchases (i.e. the positive return hurdle that must be overcome before a decision is made, which may increase as economic anxiety increases)

All 3 of these factors are moving targets. Inflation expectations have consistently underestimated inflation for over a year now, suggesting the Fed still has time before expectations become entrenched. The August 2022 reading was for 5.7% inflation in the next 12 months - a big drop from 6.8% in June.

5.7% is roughly equal to mortgage rates or preferred stock yields, and probably close to a typical small business loan, so maybe the incentive for hoarding is already nil. That's before we factor in the probability of a recession in the next 18 months. Still, I wonder why survey respondents aren't correcting for their previous inaccuracy? And why are inflation expectations plummeting - is it because of the Fed's rate hikes or media talk about imminent recession?
https://tradingeconomics.com/united-states/inflation-expectations
 
Meanwhile the FFR futures are moving in the opposite direction, with the most likely prediction for the FFR in May being 4.5%-4.75%. The odds of 4% rates by May have evaporated. Will longer duration bonds follow, or will we experience a full inversion?
https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

[wageslave23]

ChpBstrd, I'll take the contrarian position that 4% interest rates could lower inflation.  Inflation expectations for 1 yr from now are 5.7%. This is higher than current interest rates.  So businesses should be pulling forward purchases.  However, they should have rationally already made these purchases because the gap has only tightened over the last 6 months. Or at least going forward, these purchases should decrease. If the longer term inflation expectations are higher than current interest rates the purchases from further down the road would still be pulled forward. But the 3 yr inflation expectation is 2.7%. So I think 3% interest rate is now basically neutral. In summary my theory is that interest rates are only inflationary if the gap between short term inflation expectations and current interest rates is growing or if current interest rates are lower than medium term inflation expectations.  I have no data to back this up but the logic seems sound.

Based on current inflation expectations, rates rising to 4% would then be deflationary.

Your contrarian take is appreciated. It makes sense to think that as the spread between interest rates and inflation decreases, the incentive to pull ahead purchases also decreases. Maybe 6 months ago when CPI was running at 8.5% and and the FFR was 0.5%, it was a no-brainer to take out a loan or sell bonds at maybe 3-4% to buy the next year's inventory or to make infrastructure investments before the price went up. And maybe now the added risks aren't justified by the narrower spread.

However, I'm wary of:
     1) assuming that demand must exhaust itself because inventories are already high and consumers have been on a buying binge for a year and a half, OR
     2) assuming that inflation won't go up even further from here, maintaining a spread between loan rates and inflation expectations that incentivizes spending.

It is safe to assume consumer demand is insatiable, and (for the 99% of the world that are non-Mustachians) is only held back by earnings. Similarly, if there exists any incentive to hold excess inventory or pull ahead purchases, inventories and purchases will be higher than otherwise. In normal conditions, it costs more to warehouse inventories or pull ahead purchases, and so these behaviors are avoided.

You are correct that when the incentive flips, demand will plummet, and you are correct to imply that the incentive is the spread between loan rates and inflation expectations, not necessarily FFR and historical CPI. That's the much tighter spread I should be watching.

We need to model this so that we can predict the turning point. Perhaps we start with:

N=I-E-R

where...
N = incentive to hoard or pull ahead purchases (if + purchase, if - don't)
I = a typical interest rate actually available to consumers and businesses
E = inflation expectations by consumers and businesses
R = risk premium for tying up cash by pulling ahead purchases (i.e. the positive return hurdle that must be overcome before a decision is made, which may increase as economic anxiety increases)

All 3 of these factors are moving targets. Inflation expectations have consistently underestimated inflation for over a year now, suggesting the Fed still has time before expectations become entrenched. The August 2022 reading was for 5.7% inflation in the next 12 months - a big drop from 6.8% in June.

5.7% is roughly equal to mortgage rates or preferred stock yields, and probably close to a typical small business loan, so maybe the incentive for hoarding is already nil. That's before we factor in the probability of a recession in the next 18 months. Still, I wonder why survey respondents aren't correcting for their previous inaccuracy? And why are inflation expectations plummeting - is it because of the Fed's rate hikes or media talk about imminent recession?
https://tradingeconomics.com/united-states/inflation-expectations
 
Meanwhile the FFR futures are moving in the opposite direction, with the most likely prediction for the FFR in May being 4.5%-4.75%. The odds of 4% rates by May have evaporated. Will longer duration bonds follow, or will we experience a full inversion?
https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

I think the reason people are not adjusting their inflation expectations is because inflation has been so low for the past 20 yrs. I think the question is why was it so low during that time? And what has fundamentally changed about the economy since then? People are assuming nothing has fundamentally changed.  And should revert once excess demand has been flushed out or supply catches up. Supply hasn't caught up because of several factors that aren't as temporary as people keep thinking.

[blue_green_sparks]

I don't know anything about The Center for Macroeconomic Forecasts & Insights but they predict 5%, 10-year treasury rates next year:
2022-09   3.7321
2022-10   4.2966
2022-11   4.9352
2022-12   5.2070
2023-01   5.3777
2023-02   5.5382
2023-03   5.5636
2023-04   5.6144
2023-05   5.6005
2023-06   5.5721
2023-07   5.5390
2023-08   5.4865
2023-09   5.4492
https://econforecasting.com/forecast-t10y
Seems aggressive? I would lock in on some of that.