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

[maizefolk]

Forecasting future interest rates out with a precision of one one-hundredth of a basis point. It's bold. I'll give them that.

[wageslave23]

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.

If 10 yr yields reach 5+%, stocks would probably be down another 20+%. I think I'd rather buy stocks and ride the wave up. Either way it would be a great buying opportunity for everything at that point.

[MustacheAndaHalf]

I don't know anything about The Center for Macroeconomic Forecasts & Insights

At the bottom of their main page, they have a broken link that I tracked down.  You could do worse than listening to economics professors.
https://www.clucerf.org/who-we-are/team/

... but they predict 5%, 10-year treasury rates next year:

2023-04   5.6144
2023-05   5.6005
2023-06   5.5721

That may look aggressive, but it's based on using the current market consensus of a 4.5% peak Fed funds rate.
https://econforecasting.com/forecast-ffr

They predict inflation will be between 8.6% and 8.7% for the rest of 2022!  Since their other forecasts reflect market expectations, I wonder if the market expects 8.7% inflation in 3 weeks?  Could be time to invest in a market surprise.
https://econforecasting.com/forecast-cpi

[ChpBstrd]

The observation that the overnight rate and the 10y yield routinely invert right before recessions is messing with my head a bit. We cannot draw a straight line between our projections for the FFR and the 10y yield, because the FFR and 10y yield routinely invert prior to recessions. We therefore don't know the discount rate we will be applying to stock earnings six months or a year from now, even if we can correctly estimate the FFR. Six months or a year from now, stocks will be discounted / priced based on expectations for the future which are held at that time - which themselves may or may not be correct.

Optimistic near-future expectations could cause us to be correct about the higher-than-expected path of inflation and the FFR, and yet never see stocks or long-duration bonds fall to attractive valuations. Perhaps all the modeling I've done so far justifies is a speculation in the futures market for short-term debt - which I don't want to do.

What's really needed for stocks to reach compelling values is a sense of doom and pessimism to snuff out those expectations. I remember 2008-2009, and that's how it was. However there are not many ways to quantify investor sentiment, or identify a good value when sentiment seems low. Also there's no guarantee sentiment will actually get low.

Maybe I should just buy puts in USO and UNG in anticipation of recession.

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.

The U.S. still has a declining labor participation rate and an aging, static population. During the "Great Moderation" years from 2009 to 2019 labor participation fell from 65% to 63% of the workforce. This reflected an aging population, longer lifespans, and a higher dependency ratio. Many people, including me, interpreted this as a sign of Japanification. A graying population would have to increase its savings rate, slowing down the velocity of money. That's a big part of the reason inflation went nowhere during those years, despite the FFR being below inflation. Money flowed into assets instead of CPI items.

The pandemic further knocked down the labor participation rate by leading families to in-source childcare, by disabling potentially millions of workers, and by killing 1.1 million adults - 250k of which were in the workforce. These factors have led to "persistent reductions in labor supply".

https://fred.stlouisfed.org/series/CIVPART/
https://www.nber.org/system/files/working_papers/w30435/w30435.pdf

Pandemic-related risks should have increased the savings rate as consumers hunkered down for an emergency, but instead the massive stimulus programs led to skyrocketing demand - which of course hit the wall of decreasing supply from problems at production plants. Consumers also did not stay home from stores, malls, car lots, and restaurants during the pandemic to the extent one might think was rational. Sure, a lot of those consumers and the people around them died, but the misinformation kept the economy afloat.

The list of worldwide inflation causes includes a lot of items that seem temporary, including:

-Stimulus checks and welfare payments
-Emergency loans
-QE
-Low interest rates
-Production bottlenecks
-Transportation bottlenecks
-Labor shortages

The first 3 of these causes are already gone, rates are heading up fast, and the last 3 causes will be resolved if there is even a slight dip in consumption (consider how high inventories are). I didn't include the Russian war on this list because inflation was high before the war, and because the impact on US energy prices is unclear now that oil prices are lower than before the war. There is a case to be made that inflation will return to prior trends, rather than feeding upon itself like in the 70's. Powell's vow to keep rates higher for longer - and his general theory of delaying action until trends are about a year old - draw an image of a severe recession in which inflation goes to near zero as the FOMC resists pressure to cut rates. That's the path to low inflation or deflation a year from now!

[ChpBstrd]

Thanks for the forecasting links @blue_green_sparks and @MustacheAndaHalf . I'm adding these to my ridiculously long collection of economics bookmarks.

This particular committee seems to be forecasting a recession starting in H1 2023 when CPI starts dropping precipitously. Some really interesting details are in their yield curve forecast. They expect the 3mo / 10y curve to invert next month, and the 1mo / 10y curve to invert in November.

They don't expect these curves to un-invert until mid-2025, and from there the model is for a perfectly flat yield curve from 1mo to 30y until at least 2027. That's probably less of an actual prediction and more of a fill-in-the-blank, because the fall in CPI does not seem extreme or quick enough to justify a very severe recession that could cause chaos for that long. Most inversions have historically tended to to resolve before or during the recession.
https://econforecasting.com/forecast-treasury-curve

I suspect stocks could bump upwards tomorrow if the risk of a 1% hike is taken off the table, but I sold a few SQQQ puts anyway. I also took a shot at and missed a ZROZ bear put spread.

[PDXTabs]

An interesting day in the markets. I noticed in the FOMC press conference that Powell said we can expect positive real rates across the entire yield curve:
https://www.youtube.com/watch?v=E34J0b5xt60&t=1199s

[ChpBstrd]

An interesting day in the markets. I noticed in the FOMC press conference that Powell said we can expect positive real rates across the entire yield curve:
https://www.youtube.com/watch?v=E34J0b5xt60&t=1199s

I re-watched that segment 4 times. It completely clashes with the direction the yield curve is actually moving, and the historical likelihood of an upcoming FFR/10y yield curve inversion. Perhaps the FOMC will only cut rates when the entire yield curve is again positive. The 10/2, for example, remained inverted for about 9 months on and off in 1989, 10 months in 2000, and 17 months on and off in 2005-06. In today's cycle, we're at month 3. Forecasters are eyeing April or May as "the top" for the FFR:
https://econforecasting.com/forecast-ffr

In response to a question at 42:10 about whether 4.6% rates would be restrictive a year from now, he said he thinks "that's likely" and that in such a situation the FFR might have a real yield of maybe 1%.

Powell also said at 40:57 that "we probably in the housing market need to go through a correction to get back to that place" where houses are affordable. I agree, and I think the forecasted 7.5% mortgages by April should lead to such a correction:
https://econforecasting.com/forecast-mort30y

However, we cannot underestimate the damage this housing "correction" will cause. When 30y mortgage rates go from 3.5% to 7.5%, the P&I increases by nearly 50%. Consumers have been buying absolutely all the house they could afford, so for every $100k in purchasing power they had at 3.5%, they will only be able to afford $64,400 at 7.5%. That implies a 35.6% decrease in prices, even before we account for the competition factor that led to offers over the asking price in 2020 and 2021. Yet housing prices are sticky, and buyers may be willing to pay more under the assumption they can refinance to a cheaper loan in the future (assuming they can qualify). Even with that caveat, I think we're looking at 25%-30% housing price declines, minimum, with a concentration in HCOL areas, due to interest rates alone. How will people react?

Low locked-in mortgages will become a form of golden handcuffs for those who need to move for work or who bought too much house during the mania. Their breakeven on selling might not come for another 5+ years. The question for banks is whether higher unemployment will force a lot of these homeowners - who were already stretched - into foreclosure anyway, and what the recoveries on those homes will be in a world of >6% mortgages.

[Mr. Green]

@ChpBstrd there is definitely a scenario where this turns into a mini 2008-09 for housing. If rising rates drop values to where people can't refinance because they're now significantly underwater, we could see significant foreclosure activity if there are major layoffs. Expecting a huge drop in home prices certainly feels like a rational rebalancing in the face of high interest rates, especially after the runup of the last couple years. We know the world revolves around monthly payments. There is just no way monthly payments can go up by 50% or more without having a significant impact on pricing. Maybe in the first year prices will be somewhat sticky while there's still an expectation of lower rates immediately ahead. But as that sentiment wears off prices are going to fall in earnest. And this is not considering what happens if inflation continues to be stubborn. What if the FFR needs to push to 6-8% to really kill it?

[ChpBstrd]

Let's work backwards from expectations.

Here in September 2022, the Bank of New York's consumer inflation expectations survey indicated that people think inflation will be 5.7% a year from now, down dramatically from 6.8% in June.
https://tradingeconomics.com/united-states/inflation-expectations or
https://www.newyorkfed.org/microeconomics/topics/inflation

This is another data point to make the case that the inflation phase of panic is over, and we are moving on into the recession phase. If we suppose the survey respondents are 100% correct we can chart what the trailing-twelve-month CPI will look like between now and next September, and consider the implications for rate hikes / rate cuts. This simulation assumes a recession does not hit in the next 12 months. The recession might not start within 12 months given the historical lag between inversions or rate hikes and the onset of recession!

I added the CPI index values to a spreadsheet and solved for the flat monthly percent change that would equal an annualized 5.7% increase from here. The solution, which would lead to the forecast number, is roughly 0.465% per month. If the CPI index grew that much each month, annualized CPI would be 5.7% next September (i.e. 0.465%/mo is roughly 5.7%/yr).

Here's what that would look like on a month-to-month basis:

Based on Consumer Expectations
Date            CPI           MoM chg    Annual chg
2022-09-01   296.99   0.465%   8.31%
2022-10-01   298.38   0.465%   7.88%
2022-11-01   299.76   0.465%   7.63%
2022-12-01   301.16   0.465%   7.51%
2023-01-01   302.56   0.465%   7.32%
2023-02-01   303.96   0.465%   6.96%
2023-03-01   305.38   0.465%   6.14%
2023-04-01   306.80   0.465%   6.28%
2023-05-01   308.22   0.465%   5.75%
2023-06-01   309.66   0.465%   4.85%
2023-07-01   311.10   0.465%   5.36%
2023-08-01   312.54   0.465%   5.72%
2023-09-01   314.00   0.465%   5.72%
2023-10-01   315.46   0.465%   5.72%
2023-11-01   316.92   0.465%   5.72%
2023-12-01   318.40   0.465%   5.72%

Now the question is, in this no-recession scenario, in which of these months does the FOMC decide to stop raising rates? Where is it first defensible to stop the hikes?

The obvious caveat is the consumers know next to nothing about inflation. An estimate from the smart money would involve "a model that uses Treasury yields, inflation data, inflation swaps, and survey-based measures of inflation expectations." FRED publishes this metric and it is currently 4.17%:
https://fred.stlouisfed.org/series/EXPINF1YR

Based on 1 Year Market Inflation Expectations
Date            CPI           MoM chg    Annual chg
2022-08-01   295.620   0.12%   8.25%
2022-09-01   296.63   0.341%   8.17%
2022-10-01   297.64   0.341%   7.61%
2022-11-01   298.65   0.341%   7.23%
2022-12-01   299.67   0.341%   6.98%
2023-01-01   300.69   0.341%   6.65%
2023-02-01   301.72   0.341%   6.17%
2023-03-01   302.75   0.341%   5.23%
2023-04-01   303.78   0.341%   5.24%
2023-05-01   304.82   0.341%   4.58%
2023-06-01   305.86   0.341%   3.57%
2023-07-01   306.90   0.341%   3.94%
2023-08-01   307.95   0.341%   4.17%
2023-09-01   309.00   0.341%   4.17%

If this is how it turns out, I can imagine the FOMC tapering its rate hikes down to 0.25% by about March. I'm guessing the FOMC's first opportunity to make a "hold and wait" decision would be in about June or July.

Possible future FFRs:
Sept: 3.25%
Nov: 4% (+0.75%)
Dec: 4.5% (+0.5%)
Feb: 5% (+0.5%)
Mar: 5.25% (+0.25%)
May: 5.5% (+0.25%)
Jun: 5.5% (hold)
Jul: 5.5% (hold)
The CME futures markets assigns 0.2% odds to this terminal rate.
https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

As we can see, if the FOMC takes a break in June according to this scenario, the FFR would have been higher than CPI for only a month or two. We might even have a positive yield curve by then, which is one of the things Powell said the FOMC is looking for.

In the broader picture, this 4%+ drop in inflation within a year would rank among the biggest moves since 2008, which was itself the biggest drop since 1982-83. Similarly, a hike from 0.25% to 5.5% would exceed the magnitude of the +4.25% 2004-06 campaign. We haven't seen +5.25% of rate hikes in a single campaign since 1980-81.

The economy is a lot more "financialized" now than it was in the early 80's, which could lead to unexpected results, as it did in 2008. Also, equities are more priced for growth now than they were then (the S&P500's PE ratio was around 7.4 back in 1980, vs. 18.5 now) and there is more retail participation - even "apes", and far fewer barriers to panic selling!

The ride is guaranteed bumpy from here, and the opportunities will be great when there's blood in the streets and panic in the headlines.

[blue_green_sparks]

Prof. Jeremy Siegel gets animated on Fed hikes, LOL.
https://www.youtube.com/watch?v=9Xnwh_9KV3o
He was calling high inflation a year ago.
https://www.youtube.com/watch?v=t3ygJbJjocI

[habanero]

Forecasting future interest rates out with a precision of one one-hundredth of a basis point. It's bold. I'll give them that.

There is a lot of wounded boldness out there. Central bankers are becming sort of a joke (I work in rates markets).

First they were unable to predict futre inflation and interest rates. Then when inflation showed up they, especially the Fed, thought they had the ability to look thorugh it - it  being transitory and all. The fact they they were unable to predict it did not diminish their faith in being able to predict what happened on the other side of what they were unable to predict in the first place.

Now they sort of all know they screwed up massively, but will never admit it in public. There has been a lot of hubris across the globe in central banker land. They employed a ton of smart folks with fancy models but at the end of the day they had no clue as to what was going on.

[MustacheAndaHalf]

Prof. Jeremy Siegel gets animated on Fed hikes, LOL.
https://www.youtube.com/watch?v=9Xnwh_9KV3o

Professor Siegel claimed commodity prices coming down is the only thing that matters, which I view as anger clouding his judgement.  Fed Chair Powell views commodity prices as only part of inflation.  He says they are only part of the picture, and it's too early to tell if commodity price drops are sustained.

"commodity prices look like they may have peaked for now ... those developments, if sustained, could help ease the pressures on inflation".
https://www.youtube.com/watch?v=durR-4fCG2g&t=932s

Consider Russia, which could cut off energy to Europe.  That would immediately send commodity prices higher.  Would Professor Siegel then admit he's wrong?  But the Fed doesn't have the option of flip-flopping on events like that.  They need to make directional changes and be consistent.  A big part of the Fed's influence is their guidance, which causes Fed statements to be priced in to markets.  I think Professor Siegel is too focused on commodities, and too early in claiming inflation is dead.  If no uncertainty occurs, he may be right - but we won't know until later.

Professor Siegel wrote off wage increases as "catching up" with inflation.  How is that different with wage pressures fueling inflation?  As long as wages are going up at the pace of inflation, that fuels inflation, risking that it becomes entrenched.  I really think he's wrong on this point, but Fed Chair Powell just says that wage pressures are not moderating enough.  I believe a "wage price spiral" is the next phase of inflation, which Fed Chair Powell confirmed is still a risk.  I hope when Professor Siegel calms down, he'll admit a wage price spiral is a real risk, and not write it off as he did.

[EscapeVelocity2020]

I might be off base here, but with the United Kingdom cutting taxes and now the Band of England pledging to buy 65B pounds ($69.4B) of long-dated gilts (i.e. QE), won't inflation continue to get worse over there? 

And if inflation is getting worse in a significant neighboring economy, won't that make US inflation worse?

[ChpBstrd]

I might be off base here, but with the United Kingdom cutting taxes and now the Band of England pledging to buy 65B pounds ($69.4B) of long-dated gilts (i.e. QE), won't inflation continue to get worse over there? 

And if inflation is getting worse in a significant neighboring economy, won't that make US inflation worse?

Not necessarily. Collapses in the value of other currencies this year have made imports relatively cheaper for people in the U.S. Additionally, if demand in the UK collapses because prices are so high, then that's just more supply for US buyers. The dynamic where investors flee to US treasuries in times of turmoil tends to prop up the dollar and make things cheaper in the US just when we need it most. Conversely, the reverse happens to the rest of the world. Hence the saying that if the US sneezes, the rest of the world catches a cold.

Of course, this observation also reveals how badly monetary policy in the US has been handled, if despite all these disinflationary shock absorbers we still managed to hit 9% inflation. Imagine how bad it would be if this dynamic wasn't in place!

[BicycleB]

I might be off base here, but with the United Kingdom cutting taxes and now the Band of England pledging to buy 65B pounds ($69.4B) of long-dated gilts (i.e. QE), won't inflation continue to get worse over there? 

And if inflation is getting worse in a significant neighboring economy, won't that make US inflation worse?

Not necessarily. Collapses in the value of other currencies this year have made imports relatively cheaper for people in the U.S. Additionally, if demand in the UK collapses because prices are so high, then that's just more supply for US buyers. The dynamic where investors flee to US treasuries in times of turmoil tends to prop up the dollar and make things cheaper in the US just when we need it most. Conversely, the reverse happens to the rest of the world. Hence the saying that if the US sneezes, the rest of the world catches a cold.

Of course, this observation also reveals how badly monetary policy in the US has been handled, if despite all these disinflationary shock absorbers we still managed to hit 9% inflation. Imagine how bad it would be if this dynamic wasn't in place!

That's what the rest of the world IS experiencing, I think. It seems we can export the difficulty by raising our rates. Won't surprise me if our recession is last and least, resulting in a relative advance of the US compared to the global economy.

[MustacheAndaHalf]

I might be off base here, but with the United Kingdom cutting taxes and now the Band of England pledging to buy 65B pounds ($69.4B) of long-dated gilts (i.e. QE), won't inflation continue to get worse over there? 

And if inflation is getting worse in a significant neighboring economy, won't that make US inflation worse?

Not necessarily. Collapses in the value of other currencies this year have made imports relatively cheaper for people in the U.S. Additionally, if demand in the UK collapses because prices are so high, then that's just more supply for US buyers. The dynamic where investors flee to US treasuries in times of turmoil tends to prop up the dollar and make things cheaper in the US just when we need it most. Conversely, the reverse happens to the rest of the world. Hence the saying that if the US sneezes, the rest of the world catches a cold.

Of course, this observation also reveals how badly monetary policy in the US has been handled, if despite all these disinflationary shock absorbers we still managed to hit 9% inflation. Imagine how bad it would be if this dynamic wasn't in place!

That's what the rest of the world IS experiencing, I think. It seems we can export the difficulty by raising our rates. Won't surprise me if our recession is last and least, resulting in a relative advance of the US compared to the global economy.

I'm not that familiar with currency markets.  Can you expand on that?  I know strong USD helps in some ways, but I don't quite get how.

Also, if you come across data suggesting the US could be last and least, I'd be interested in that.

[ChpBstrd]

The National Financial Conditions Index (NFCI) took a dip in July and August, but is now approaching zero again. This suggests tightening financial conditions and more stress in the debt markets.


Meanwhile M2 is still holding steady.


Initial claims are steady...


Durables are steady...


Things look fairly bleh, with no discernable trends in many of the metrics I'm watching. However, the yield curve inversion is getting deeper. On Friday, the 10-2 inversion hit -0.51%, which is deeper than it went in 2006, 2000, or 1989.


PCE gets released on Friday. My prediction is for PCE to be flat, due to precipitously falling commodities prices.
https://www.bea.gov/data/income-saving/personal-income

About those commodity prices: The past 30 days have seen the GSCI fall 16.3% and the CRB index fall almost 19%.
https://tradingeconomics.com/commodity/gsci
https://tradingeconomics.com/commodity/crb
This is to me a reaction to the 0.75% September rate hike, and reflects anticipation of a recession happening sooner than initially thought. You don't want to be long commodities when the recession hits, so there's a game of musical chairs going on.

This is how recessions can postpone themselves for a year or more: Heightened risk of holding commodities futures or inventories puts downward pressure on commodity prices, which lowers producer prices, which lowers consumer prices, and which lowers the necessity of more large rate hikes. July and August already saw negative PPI growth (i.e. producer price deflation) thanks to commodities.
https://fred.stlouisfed.org/series/PPIACO
Also, economic uncertainty and/or rate hikes tend to increase the flow of investment dollars into US treasuries, propping up the dollar, and further lowering the price of imports for U.S. consumers.

Then, as we all know, lower prices lead to more consumption, which leads to economic growth and low unemployment. These feedback cycles are being missed by the people shouting that we're already in a recession, or that we will be in recession by the end of 2023. There are reasons why we usually go a year or two after yield curve inversion, before actually experiencing recession. Interest rates actually plateaued and then were cut just before the 2020, 2008, 2001, and 1990 recessions, in response to the sort of falling price signals we're seeing now.

The FOMC is taking flak from pundits like Jeremy Siegel, who argue that the disinflation in each of the past 2 months is the recession warning we should be watching, not trailing-12-month numbers that mostly reflect price changes that happened long ago. These same pundits will be calling the recession and demanding rate cuts at the first sign of a blip in initial claims - or trouble in any market. That day will come, but for now it looks to me like we're in the burn-up phase prior to recession.

If commodities and producer prices fall again in September, I think we might be looking at a 0.5% rate hike in November, an outcome the FFR futures market thinks is 12% more likely than it was a week ago (now assigned 42% odds).

[BicycleB]

I might be off base here, but with the United Kingdom cutting taxes and now the Band of England pledging to buy 65B pounds ($69.4B) of long-dated gilts (i.e. QE), won't inflation continue to get worse over there? 

And if inflation is getting worse in a significant neighboring economy, won't that make US inflation worse?

Not necessarily. Collapses in the value of other currencies this year have made imports relatively cheaper for people in the U.S. Additionally, if demand in the UK collapses because prices are so high, then that's just more supply for US buyers. The dynamic where investors flee to US treasuries in times of turmoil tends to prop up the dollar and make things cheaper in the US just when we need it most. Conversely, the reverse happens to the rest of the world. Hence the saying that if the US sneezes, the rest of the world catches a cold.

Of course, this observation also reveals how badly monetary policy in the US has been handled, if despite all these disinflationary shock absorbers we still managed to hit 9% inflation. Imagine how bad it would be if this dynamic wasn't in place!

That's what the rest of the world IS experiencing, I think. It seems we can export the difficulty by raising our rates. Won't surprise me if our recession is last and least, resulting in a relative advance of the US compared to the global economy.

I'm not that familiar with currency markets.  Can you expand on that?  I know strong USD helps in some ways, but I don't quite get how.

Also, if you come across data suggesting the US could be last and least, I'd be interested in that.

I don't have data*; am following up on the logic we've already stated.

You've explained how us raising rates causes inflation elsewhere, even while the resulting lower prices from our viewpoint help us delay our recession. If they're suffering increased inflation while ours is moderating, it seems that they are suffering an economic headwind while we are getting a tailwind. I therefore imagine that their recessions will start sooner than ours. Similarly, while their pain softens our recession, causing inflows to us of cheap imports and (I assume) extra capital, it seems like their recessions would be worsened by the high cost of imports that they experience, plus their outflow of capital. So I figure their recessions will be worse as well as sooner. "Last and least" summarizes the presumed effect. Perhaps there would be exceptions even if the trend mostly as I describe, though if we're the driver, perhaps it would be literally true.

*Strictly speaking, I noticed anecdotally a couple months ago that when US raised interest rates, the dollar got stronger against multiple currencies. I was in Medellín Colombia and my friends there felt that the plunge in the Colombian peso (COP) vs the USD was due to the then-recent election of Colombia's new President, perceived to be a negative economic influence. I compared the % change with other currencies, found USD had strengthened against multiple others (EUR, GBP) by the same 10% as COP, and concluded the reason was US interest rates, not Colombian policy. But I don't have recent or comprehensive data, it's just a supportive anecdote.

In my mind, other Colombian anecdotes I noticed support your theory and my extension of it. Colombian inflation has been higher than USA's, for example. But again, nothing comprehensive.

[ChpBstrd]

There's no FOMC meeting in October, which makes it the perfect time for the bear market rally we're seeing now, just like August was. However, the next release of CPI data is looming and could burst the bear rally, just like what happened in August when we saw Core CPI expand despite falling commodities. CPI and Core CPI for September will be released on Thursday morning, October 13. The question is whether history will repeat, and disappointment over still-high CPI and Core CPI will end the latest rally.

Commodities - a key cost driver for everything - have been falling for three months straight:

S&P GSCI month-to-month change in average of daily price levels:
Jul '22: -12.44%
Aug '22: -1.25%
Sept '22: -5.58%

3-month cumulative GSCI loss:
-18.36%

It would be a weird world in which such massive commodity price drops did not translate into lower inflation, and surprisingly low inflation numbers are what the people plowing into stocks this week are betting on. Yet, producers are still catching up in terms of passing on cost increases to consumers and wage increases to workers. That's what we saw in the higher than expected August Core CPI numbers, and the trend could continue into September. PPI growth has turned negative with the commodities correction, but it seems unlikely to me that corporations will decide to take the losses from the commodities spike. Reported margins for S&P500 companies took a dip in Q2 2022 due to the sudden cost increases, and I think we'll see them try to claw back those inflation-driven margin losses, and to position themselves more favorably if high inflation continues.
https://www.yardeni.com/pub/sp500margin.pdf
We often comment about how the Federal Reserve was behind the curve on inflation, but corporations are even further behind. The PPI was 15% higher in August than 12 months before, but prices measured by Core CPI increased at less than half that rate.

So I see it as a tug-of-war between falling commodities and price hikes by corporations trying to protect their margins.

Soon-to-be-embarassing prediction:
September Core CPI: 5.8%
September CPI: 8.1%

[BicycleB]

@ChpBstrd, may I mention my great admiration for your thoughtful approach and persistent posting? Being right is difficult, but right or wrong, your thoughts are illuminating.

What confuses me is questions like "When do people absorb news and change their value estimates based on it?" It seems like a variable that change results from logical to illogical in a moment.

In my own baffled mind the long term questions are hard to be sure of, and investors seem to keep swinging their views by 5% to 10% of S&P prices in a few weeks based on reactions to various changing tea leaves (even though the tea leaves are real data). I'm not sure the tea leaves are reliably telling us much yet, but then since the swings in value later from a good or bad outcome are probably more than 10%, maybe the swings are still rational for people who hope they're using the tea leaves to get ahead of a bigger swing. Kudos for at least taking a very reasonable crack at this.

[ChpBstrd]

Let's explore the bull case for stocks, because the risk of sitting too long on the sidelines is equal to or greater than the risk of jumping in too soon.

First, inflation is forecast to plummet in the next several months:
https://www.forecasts.org/economic-indicator/inflation.htm
This would reduce pressure on the FOMC and encourage them to start tapering down their rate hikes to 0.25% by early 2023, and to cease rate hikes soon thereafter.

The CME futures market and the Fed's dot plot are forecasting a peak federal funds rate upper bound of 4.5% or 4.75% next Spring.
https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html
https://www.financialexpress.com/investing-abroad/featured-stories/us-fed-dot-plot-september-2022-with-target-level-for-the-federal-funds-rate/2686380/

I've already established that the 10y treasury yield routinely inverts against overnight rates in times of market stress. So the forecasted peak of 4.5% in the FFR might occur at the same time as 10 year yields of 4% - or lower. Against that backdrop, the S&P500's current earnings yield of 5.26% - and growing at 5-6% per year after the recession - provides a historically typical risk premium.
https://forum.mrmoneymustache.com/investor-alley/inflation-interest-rates-share-your-data-sources-models-and-assumptions/msg3059511/#msg3059511
https://www.multpl.com/s-p-500-pe-ratio/table/by-year

Meanwhile the 5 year inflation breakeven rate is down to 2.26% and still falling.
https://fred.stlouisfed.org/series/T5YIE/

Markets entered this tightening cycle months ahead of the Fed. The correction started in January, even though the first small rate hike didn't happen until March. This is atypical. Before the pandemic, the stock market peaked an average of 10 months AFTER the yield curve inversion, and this time stocks peaked about six months BEFORE.
https://www.isabelnet.com/10y-2y-yield-curve-inversion-vs-sp-500-peaks/

If stock investors are now ~12-16 months ahead of the usual cycle / cadence, then it is possible we've already hit bottom and stocks could rally through the recession in anticipation of future rate cuts. The rallies of the last two days could represent the bottom of the V.

But how healthy is the consumer?

Unemployment is 3.7%, near all-time lows.
https://fred.stlouisfed.org/series/UNRATE

Household debt service payments as a percentage of disposable personal income is at all-time-record lows. I.e. there has never been a more affordable time to be holding a mortgage, a car loan, a HELOC, etc. Consumers are less stretched than ever before.
https://fred.stlouisfed.org/series/TDSP

And that's why delinquency rates on credit cards and bank loans are also near record lows:
https://fred.stlouisfed.org/series/DRCCLACBS
https://fred.stlouisfed.org/series/DRCCLACBS

Wells Fargo recently estimated consumers are still sitting on up to $2.1T in "excess savings" from stimmie checks and foregone spending during the pandemic etc:
https://finance.yahoo.com/news/consumers-still-have-13-trillion-in-extra-spending-power-morning-brief-100026042.html

Consumers' 3.5% personal savings rate is near the lows that occurred in 2006-2007...
https://fred.stlouisfed.org/series/PSAVERT

...and they are plowing those savings into both durable and non-durable goods at an unusually fast pace, perhaps to avoid future price hikes.
https://fred.stlouisfed.org/graph/?g=Urjb

Credit card balances just hit pre-pandemic levels in nominal terms:
https://fred.stlouisfed.org/series/QBPBSTASLNINDVCRD

Overall, consumers look like they still have at least six months of shop-till-you-drop spending ahead, and we are likely to hear analysts talking about a record xmas shopping season.

The almost all-good consumer data seems to be in contrast with the projections for rapidly falling inflation and a Fed "pivot". Is that because the inflation forecasts and markets are applying theoretical wishful thinking that ignores the health of consumers, or is it because the forecasters and markets are anticipating that "something breaks" between now and next Spring.

For example, maybe Eurozone & UK households are not in such good shape, with lower savings to draw upon, higher inflation than the US, currency devaluation, skyrocketing utility bills, and their recession will quickly drag the US down too. Can US 30 year mortgages really go up 4% in 18 months and not cause another meltdown in housing prices?

As another example, how long do we really have before a couple of emerging market countries - or a southern European country - go into debt crisis?
Those falling commodities prices generally come out of their pockets, and the skyrocketing dollar increases the real cost of their debts.

However, if such a crisis comes, it will only further depress the 10 year treasury yield which is used to anchor the discount rate which is the basis of stock valuation. So maybe our worst-case fears can be interpreted as reasons for the rate hikes to end, the 10y treasury to fall from here, and for stock prices to go up in the meantime. That's how stocks could rally through the recession or coming crisis.

[MustacheAndaHalf]

First, inflation is forecast to plummet in the next several months:
https://www.forecasts.org/economic-indicator/inflation.htm
This would reduce pressure on the FOMC and encourage them to start tapering down their rate hikes to 0.25% by early 2023, and to cease rate hikes soon thereafter.

They are full of shit.  Error bars of 0.13 for December 2022 inflation?  They lack humility when they screw up - no admission of it on their website, I notice.  Luckily, I know about something called "The Wayback Machine", which fetches web pages and stores them for posterity.

https://web.archive.org/web/20220120073029/https://www.forecasts.org/economic-indicator/inflation.htm
Back in Jan 2022, they also predicted inflation would fall rapidly to 5.00% in June 2022.  They used error bars of 0.13 to show their false precision, and were off by by 1.6x as inflation came in over 8%.  If they can't even get the first digit right, they should not be pretending their predictions have 0.13 precision.

Now I hear you say "What about Russia's invasion of Ukraine?"  Okay, fair enough, let's look after that war, to see their updated predictions in April of this year, a full month after the invasion.
https://web.archive.org/web/20220411094057/https://www.forecasts.org/economic-indicator/inflation.htm

This time, June was 7% ... and July had rapidly falling inflation to 5.94%.  They predicted August inflation of 5.73%, again off by several percent.  These people have been wrong by a wide margin repeatedly, and refuse to change their prediction.  They always predict inflation will fall rapidly.  And when they're wrong repeatedly, they keep providing the same wrong predictions.

It's one thing to be very wrong about predictions, but it's another level of arrogence to apply narrow errors bars after being so wrong repeatedly.  Their prediction is wrong, but their false precision is even worse.  Also note the lack of contrition on their website - I had to catch them being full of shit, since they do not show their past failed predictions prominently.

[EscapeVelocity2020]

I appreciate you trying to hold both the bull and bear cases up for scrutiny @ChpBstrd but you do seem to hold a bias toward the bullish cases.  I am long US equities, so I'd like for you to be right and I also have no idea what will happen when and if 'something breaks' and the Fed is forced to either cut or raise rates (or, most likely, return to QE).  Maybe we do get a giant rally...  along with giant inflation.

I don't see much evidence for the Fed to be believable on their CPI forecasts (as MustacheAndaHalf so eloquently discussed).  Any time there is but a whiff of hope, markets go bonkers and commodities follow.  Still plenty of dry powder to drive risk assets up and inflation along with it.  I don't know why fears of Recession continue to subside, when pretty much everywhere in the world is catching financial contagion.  It's a race to the bottom out there!  Maybe the US can pull the global economy through this, but it'd be a helluva big accomplishment that I just can't imaging Jerome Powell is capable of.  His credibility is thinning every time he opens his mouth...

To break the back of inflation, there is going to need to be higher rates.  Maybe not Taylor Rule rates, but the Fed needs to hold the line that they are willing to go there.

[PDXTabs]

First, inflation is forecast to plummet in the next several months:
https://www.forecasts.org/economic-indicator/inflation.htm
This would reduce pressure on the FOMC and encourage them to start tapering down their rate hikes to 0.25% by early 2023, and to cease rate hikes soon thereafter.

I like your "consumer is still strong and still spending" take but I didn't bother quoting it here. I will point out that the St Louis Fed Inflation Nowcast is higher than the forecast.org numbers:
https://www.clevelandfed.org/our-research/indicators-and-data/inflation-nowcasting.aspx

And a core PCE in the 5% range could still lead to a 7% Fed funds rate.

But I'm long world equities so what do I know.

[ChpBstrd]

First, inflation is forecast to plummet in the next several months:
https://www.forecasts.org/economic-indicator/inflation.htm
This would reduce pressure on the FOMC and encourage them to start tapering down their rate hikes to 0.25% by early 2023, and to cease rate hikes soon thereafter.

I like your "consumer is still strong and still spending" take but I didn't bother quoting it here. I will point out that the St Louis Fed Inflation Nowcast is higher than the forecast.org numbers:
https://www.clevelandfed.org/our-research/indicators-and-data/inflation-nowcasting.aspx

And a core PCE in the 5% range could still lead to a 7% Fed funds rate.

But I'm long world equities so what do I know.

I made up my September CPI estimate before I encountered some of these sources for forecasting, but it looks like all our September estimates are in a tight range except for the outlier, econforecasting.com.

Me: 8.1%
Current Fixings Market*: 8.1%
Cleveland Fed Nowcast: 8.2%
econforecasting.com: 8.68%

*https://www.marketwatch.com/story/cpi-fixings-traders-nudge-up-expectations-after-opec-agreement-now-see-annual-headline-inflation-rate-of-75-for-october-2022-10-05?mod=mw_latestnews

With expectations as narrow as they are, and with the market consensus probably best represented by the fixings market and nowcast, there could be a big move on 10/13 if inflation is even slightly outside the 8.1/8.2% range. If past months are any guide, these big moves - usually in response to inflation disappointments - take a couple of days to reach full effect. Thus there may be an opportunity for someone to go long or short at the open next Thursday morning when they receive the data and have a contingency plan for either outcome.  A game plan for a small speculation might look like:

If CPI > 8.3% or CoreCPI > 6.8%, short the market
If CPI < 8% or CoreCPI < 6.4%, go long the market

Of course, in the big picture a rapid decrease in inflation will signal the onset of recession and the devastation of corporate earnings. But traders assume a recession is too far away to affect the value of stocks today. The soft-landing signal is for inflation to fall a bit faster than forecasted, because that implies the FOMC could reverse course before a recession starts, cut rates and do QE through the recession, never hit a very high terminal rate, and have a short shallow recession if it counts as a recession at all.

Monday and Tuesday's sharp upward market moves prove there is a lot of optimistic money still on the sidelines awaiting a signal to jump back in, or to hold out a little bit longer. Maybe Australia only raising rates 0.25% was mistaken for such a signal, but we can at least see that we're nowhere near peak pessimism. Bottoms look like headlines fretting over job losses, bankruptcies, financial crises, whether capitalism has a future, etc. and I'm not seeing that.

[EverythingisNew]

Just want to say that I enjoy reading your thoughts @ChpBstrd. I especially liked your explanation of how stocks can move up into a recession as lower commodity prices provide relief.

[Reynold]

[snip]
Commodities - a key cost driver for everything - have been falling for three months straight:

S&P GSCI month-to-month change in average of daily price levels:
Jul '22: -12.44%
Aug '22: -1.25%
Sept '22: -5.58%

3-month cumulative GSCI loss:
-18.36%

It would be a weird world in which such massive commodity price drops did not translate into lower inflation, and surprisingly low inflation numbers are what the people plowing into stocks this week are betting on.

I don't think nearly as much of the U.S. economy is dependent on commodity prices as it was during the last big bout of inflation, in the 1970s.  The U.S. economy has been getting "lighter", i.e. less weight of physical stuff per dollar of GDP, for decades as heavy, low margin commodity manufacturing has been outsourced to other countries, and we make more high value added items or services where raw materials are a fairly small fraction of the value. 

I think that is one reason for the Fed continually underestimating future inflation and the interest rates needed to fight it, as MustacheAndaHalf says above.  I know I got a good laugh back in the late spring (?) when inflation passed 8% and Powell was saying it would be back down to 2% by raising interest rates to maybe 3%, that didn't exactly happen last time inflation was this high.  I've also read that changes in the way inflation is measured means it is actually closer to those double digit rates of the late 1970s than we realize, and they didn't come close to killing that with interest rates of 4-5%. 

I'm friends with people with both low incomes and high incomes.  All of them are "worried" about inflation, but none of them plan any significant belt tightening, because one way or another they all came out of the pandemic in pretty good financial shape.  They know there are plenty of jobs if they want them (some of the low income folks don't even want them, they are fine with government benefits and odd jobs on the side).  I don't actually expect that situation to change much even with Fed tightening, because so many people have dropped out of the job market.  In addition to many people moving retirement up some during the pandemic, I saw statistics that 1/3 of all working age men are not in the job market.  Not employed, and not looking. 

Therefore, I predict CPI will still be above 6%, very likely above 8%, at the end of 2022, the U.S. economy will still be doing fairly well, and the Fed will, to their eternal surprise, still be trying to catch up.  Some time early in 2023 a recession may be achieved that lowers inflation, but it is going to be rather different from the last ones employment wise.  I also predict the S&P P/E ratio will never drop below 15 before it goes back up, there is too much investment money sloshing around that will want to buy on dips, it has worked for decades now. 

I also think things are going to get rough for developing countries, as commodity prices drop while their borrowing rates, often denominated in dollars, go up and they pay more for the developed world's products.  Things will also get tough for Europe because of the energy situation they put themselves in with dependency on Russia, green energy is volatile and expensive, and despite their grand plans they aren't close to going fossil fuel free. 

[jpdx]

Thoughts on the latest Krugman?

[PDXTabs]

Thoughts on the latest Krugman?

I'm on team Furman.

[SpaceCow]

Krugman's argument seems to boil down to the same argument the led to Team Transitory. It seems more logically than empirically based. The pandemic caused supply to decrease relative to demand, raising prices. An adverse supply shock. He rightly points out the risks associated with an overreaction from the Fed. However, he doesn't get into the other side of the coin--the risks that a dovish fed allows inflation expectations to become entrenched.

I think Krugman is stuck in Team Transitory mindset when he should be looking at the situation in front of them at this point in time. He's worrying about a bump in the road 5 miles back instead of adapting to the sharp turn the economy is rapidly approaching.

Just want to say that I enjoy reading your thoughts @ChpBstrd. I especially liked your explanation of how stocks can move up into a recession as lower commodity prices provide relief.

I second this. It's a very cool thread.

[ChpBstrd]

I don't think nearly as much of the U.S. economy is dependent on commodity prices as it was during the last big bout of inflation, in the 1970s.  The U.S. economy has been getting "lighter", i.e. less weight of physical stuff per dollar of GDP, for decades as heavy, low margin commodity manufacturing has been outsourced to other countries, and we make more high value added items or services where raw materials are a fairly small fraction of the value. 

I think that is one reason for the Fed continually underestimating future inflation and the interest rates needed to fight it, as MustacheAndaHalf says above.  I know I got a good laugh back in the late spring (?) when inflation passed 8% and Powell was saying it would be back down to 2% by raising interest rates to maybe 3%, that didn't exactly happen last time inflation was this high.  I've also read that changes in the way inflation is measured means it is actually closer to those double digit rates of the late 1970s than we realize, and they didn't come close to killing that with interest rates of 4-5%. 

It's a good point, and why the correlation between commodities and inflation is probably less now than ever. What does the price of iron ore in China have to do with the wages of tech workers in San Diego? The WFH revolution, and to a lessor extent hybrid and BEV cars, are helping to insulate a lot of Americans from oil prices. And of course the U.S. is primarily an economy based on providing services to each other. Maybe these factors make inflation more of a "monetary phenomenon" than in years past? But then again all these factors were also in place during the 20-teens, when money supply skyrocketed and inflation was below-target.

The absurdity of early-2022 market expectations that 3% interest rates were going to bring down 7-9% inflation by the end of 2022 is what sparked this whole thread. And yet, as Krugman laments, we don't know the exact interest rate that will cause the economy to "roll over" into disinflation. Maybe it's 4%? Maybe it's 6%? Maybe it's 9%? What we do know is that the rollover point is out there somewhere, and the longer interest rates rise the higher that chances that we've arrived.

So if one was to pile into SQQQ or SARK, or to short TLT or ZROZ, because one expects interest rates to reach at least 5% or 6% before inflation rolls over, then one would immediately be struck with fears that inflation would do something other than expected.

Inflation could do anything because we have no good reason to expect any particular outcome. We should be less confident about the possibility of a roll-over now than we were in the spring, when the rates-inflation gap was much larger. There is no working model or theory right now, other than not fighting the fed!

The Possible Experiment
The Fed's own theory hypothesis, as leaked by Atlanta Fed President Raphael Bostic this week, seems to be that rates in the 4% to 4.5% range are restrictive.
https://www.msn.com/en-us/money/markets/fed-e2-80-99s-bostic-wants-to-pause-after-december-rate-hike/ar-AA12DJva

San Francisco Fed President Mary Daly chimed in to say:

I see us raising to a level that we believe is restrictive enough to bring inflation down and then holding it there until we see inflation truly get close to 2%,

https://www.marketwatch.com/story/feds-daly-says-more-rate-hikes-needed-dismisses-pivot-talk-11664983472?mod=search_headline

This is an update from Jerome Powell's circa-3-months-ago concept that 2.5% was a "neutral rate" and suggests that the FOMC might attempt a slower pace of rate hikes as they think we're approaching the hidden rollover point, so as to not overshoot on interest rate hikes more than necessary. Rather than overshoot the rate hikes, only to reverse shortly thereafter, the FOMC might try to hold a lower-than-inflation-but-theoretically-restrictive interest rate for a while (like several months or a year) to see if inflation can be controlled without the FFR exceeding inflation. Such an experiment would align with their dual mandate, and is essentially the only option other than a series of 0.75% hikes until the FFR hits 6-8% and a recession becomes unavoidable. This sort of talk feeds into the narrative of a "mild and short recession with the highest rates near 4% and rate cuts in late 2023". The bond market is clearly optimistic, either about the possible experiment working or about a very severe recession or both, because the 2 year breakeven inflation rate is a mere 3.18%. Team transitory is in treasuries!
https://fred.stlouisfed.org/series/EXPINF2YR

However, it remains to be seen if dragging the brakes to gradually slow the economy is an appropriate metaphor. If interest rates must exceed inflation to reduce demand, as I think we saw in previous decades, then the proposed experiment would fail and we might find ourselves in April 2023 with >7% inflation and a 4% FFR. This is the crux of the disagreement between Krugman and Furman (although each are primarily thinking about the impacts of economic outcomes on elections). Is doing such an experiment worth it? Tens of millions of people's jobs and retirements hang in the balance. And even if the experiment fails, economic inequality will have been reduced and the national debt would have become a LOT more sustainable.

Known Unknowns
But let's admit what we don't know. We don't know if this proposed experimental pause will be performed, or if the FOMC will continue to raise rates aggressively until we hit recession. If the experiment is performed, we don't know if inflation will rise or fall as a result.

I also don't think we know for sure how much 2020-2021 stimulus money remains in consumers' pockets. The chart below by Wells Fargo seems to conflict with government data on savings, and my attempts to get to the bottom of this discrepancy have gone nowhere. BLS data says consumers have spent more than they earned for 6 out of the last 7 months, which alongside a 3.5% savings rate and falling deposits, implies they are about to run dry.

Total household deposits have "rolled over":
https://fred.stlouisfed.org/series/TSDABSHNO

Net private savings are falling below pre-COVID levels:
https://fred.stlouisfed.org/series/W986RC1Q027SBEA

[MustachioedPistachio]

Just want to say that I enjoy reading your thoughts @ChpBstrd. I especially liked your explanation of how stocks can move up into a recession as lower commodity prices provide relief.

Chiming in too to say I've really enjoyed reading the analyses!

[EscapeVelocity2020]

Yup, this revelation the other day blew my mind - Consumers still have $1.3 trillion in extra spending power

And the US has stubbornly low unemployment...  Inflation report next week might be irrelevant.  Even if it is down, it's hard to believe that the Fed is having very much influence with rate hikes.  My simple theory is that pandemic QE (and ongoing global QE) is making hiring workers 'cheap' for companies awash in cheap capital that can continue to raise prices.  Consumers are grumbling, but apparently can continue to 'afford' this inflation.  For all the vague talk about things 'breaking', I have yet to see a detailed analysis quantifying what is breaking and how much economic damage it is causing.

Estimates of future FFR's is steadily going up...  Of course, if traders pile on to the short side, there will be an explosive rally, so I'm not giving trading advice.  Me thinks that Elon Musk's  Twitter purchase debacle will define this era, if anyone ever wants an answer to the question of if the pandemic QE package was too large!

[ChpBstrd]

To clarify the end of my last post where I left some dots unconnected:

The risk to anyone shorting this market - even if one's theory about FFR having to be greater than CPI is correct - is that the FOMC tries the pausing experiment in early 2023, at their target rate around 4-4.25%. That pause in rate hikes could coincide with slightly higher unemployment and slightly lower consumer spending due to consumers running out of savings. The market might declare "the bottom is in" and pile into equities as soon as that scenario seems halfway plausible.

This article summarizes the attitude. Traders are looking for the pivot point where inflation rolls over. Even though inflation measures are noisy, that's the bottom signal. It doesn't matter if you can spot the fallacy in this quote - what matters is what the stock market will do!

Historically, the amount of time it takes for inflation to spike is equal to the amount of time it takes for the spikes to reverse. Inflation probably peaked in March or April of this year, and it started to heat up in April 2021. This tells us the spike took a year to form, which suggests inflation will be back to levels that are not worrisome by next spring or early summer

Despite all the noise, the hard part for me is not entering into a very long duration bear spread. Dispense with the hand-wringing - we're heading toward recession. And if you bet on a scale of a year or more, 50% returns can be yours. The thing that holds me back is the historical record of market runs between yield curve inversion and the start of recession. Unless we get a big rally, I'll sit on the sidelines and let the market come to me.
https://www.marketwatch.com/story/inflation-is-going-to-fall-just-as-fast-as-it-rose-and-thats-investors-cue-to-enter-the-stock-market-11665072070?mod=home-page

[MustacheAndaHalf]

The claim of equal time for inflation and deflation doesn't hold for the last time inflation was this high, 40 years ago.  The article below points to 1965 - 1983 as "the Great Inflation", where inflation spiked repeatedly and then collapsed.
https://www.federalreservehistory.org/essays/great-inflation

(That website lists numerous Federal Reserve bank employees as authors)
https://www.federalreservehistory.org/authors

Inflation rose rather high in 2021, then spiked after Russia's invasion of Ukraine.  I don't think a simple timeline or rule will apply to these complex events.

[BicycleB]

To clarify the end of my last post where I left some dots unconnected:

The risk to anyone shorting this market - even if one's theory about FFR having to be greater than CPI is correct - is that the FOMC tries the pausing experiment in early 2023, at their target rate around 4-4.25%. That pause in rate hikes could coincide with slightly higher unemployment and slightly lower consumer spending due to consumers running out of savings. The market might declare "the bottom is in" and pile into equities as soon as that scenario seems halfway plausible.

This article summarizes the attitude. Traders are looking for the pivot point where inflation rolls over. Even though inflation measures are noisy, that's the bottom signal. It doesn't matter if you can spot the fallacy in this quote - what matters is what the stock market will do!

Historically, the amount of time it takes for inflation to spike is equal to the amount of time it takes for the spikes to reverse. Inflation probably peaked in March or April of this year, and it started to heat up in April 2021. This tells us the spike took a year to form, which suggests inflation will be back to levels that are not worrisome by next spring or early summer

Despite all the noise, the hard part for me is not entering into a very long duration bear spread. Dispense with the hand-wringing - we're heading toward recession. And if you bet on a scale of a year or more, 50% returns can be yours. The thing that holds me back is the historical record of market runs between yield curve inversion and the start of recession. Unless we get a big rally, I'll sit on the sidelines and let the market come to me.
https://www.marketwatch.com/story/inflation-is-going-to-fall-just-as-fast-as-it-rose-and-thats-investors-cue-to-enter-the-stock-market-11665072070?mod=home-page

I think you're wrestling a key issue - even if you're right about long term trends (inflation persisting, stock prices eventually dropping more), when will the predicted events happen? I agree that results could easily take a year or more, and in between, there could be a big rally.

Has Larry Summers' model been discussed already in this thread? If I understand correctly (I may not!), it's just three elements:

1. There's a bedrock inflation rate in the current economy (I think his guess is roughly 4 to 4.25%). He has a more precise term than that, sorry I can't find it rn
2. Taming inflation requires Federal Funds Rate over the bedrock inflation rate (BIR for this discussion)
3. The necessary amount of FFR "overage" is about 5 percent-years. In other words, if x is FFR-BIR, and y is how long they keep FFR that high,  x times y = 5.

Example:
BIR =4.25
FFR = 5.75
Difference = 1.5
5 / 1.5 = 3.33, they need to keep the rate that high for 3 years and 4 months or they fail to break the inflation cycle

If true, I think this model supports several conclusions this thread has arrived at previously:
a. Higher interest rates still inevitable, probably higher than people think
b. Could come as soon as spring
c. If they don't come soon, inflation keeps growing
d. Soft landing ain't gonna happen
e. Rallies now are probably sucker's rallies (if inflationary recession does lead to a big selloff by discouraged investors)

Also some not frequently specified yet:
d. This could take a LONG time to fix
e. It would be easy for Fed to stop too early, leading to repeated inflation bursts and even repeated recessions
f. Alternatively, insufficient Fed response could delay The Big Recession for years, only to increase its intensity when it comes (similar to 1980-82 era, maybe worse)

I apologize for not posting the article I first saw on this a week or two ago. Now Google is only bringing me data- and model- light articles with doomish quotes, and a paywalled article on Fortune where the Google search hits the model points 1 and 2, and mentions "5.0 to 5.5" as the FFR rate Summers thinks the Fed should settle on.

https://fortune.com/2022/09/23/economist-larry-summers-inflation-economy-prediction/

[ChpBstrd]

Thanks for finding that model @BicycleB ! That's exactly the sort of thing I'm looking for. Without evaluating the rationale for Summers' model, it would seem like any attempt by the FOMC to avoid overshooting on the "FFR overage" will only prolong the amount of time rates have to be high. However I'll have to read more about his model because it doesn't make intuitive sense to me.

From the FOMC's perspective, there's nothing to lose if they switch to 0.25% hikes in early 2023. If the recession hits in 2023, they'll be glad they didn't overshoot by doing 0.75% hikes all the way to 8% or 9% only to backtrack amid economic carnage. If the experiment works, a FFR lower than CPI manages to lower CPI, and the recession is mild, then they will have broken new ground in the debate over how to deal with inflation, and they will be remembered for masterfully maneuvering through these tricky times. In either outcome they will have maximized their full employment mandate, and in either outcome inflation goes down eventually. If this period of ~8% inflation is prolonged a year or so then - well - the US has $31 trillion in debt that just got a $2.48T reduction in real terms. Then the inevitable recession knocks down interest rates and we're back to paying low interest rates on the national debt after a brief currency reset.

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

Here's Wells Fargo's latest take on yield curve inversions. The 1y/10y inversion has predicted 100% of recessions, with only one false positive back in 1966, and with an average lead time of 12 months. Accounting for the false positive, the 1/10 curve has 91% reliability. Thus according to Wells Fargo, in unusually blunt terms:

Recently, the 10-year/1-year spread inverted in July and breached the recession-prediction threshold in August. Based on the spread's average lead time, the inversion indicates that there is a 91% probability of a recession occurring during the next 12 months.

https://wellsfargo.bluematrix.com/links2/html/87ba3ecd-87b4-4e4e-aa5f-adb0fca3f712

[MustacheAndaHalf]

Jamie Diamond (JP Morgan's CEO) predicts recession in 2023.  I think markets overreacted to that news yesterday, falling on bearish rumors.

The S&P 500 recently fell near its 52 week low, which has happened before in June and September.  Both prior times, the S&P 500 bounced upwards off that low as buyers entered the market.  The volatility index seems to bounce between $20 and $35 in this market, and almost hit $34 earlier today.  Volatility looks like it has room to fall.

Finally, CNN's fear & greed index shows a value near 20 (extreme fear), which tends to be on the lower side (but not a maximum value).
https://edition.cnn.com/markets/fear-and-greed

On Thursday we get CPI-U data for September.  Many CPI-U prints have been higher than expected, which I think will cause investors to overestimate inflation.  Multiple professional investors have mentioned softening (lower) inflation, which I think is the most likely scenario: CPI-U lower than expected.  I expect markets to go higher Thursday morning.

[blue_green_sparks]

Besides the inflation, looming recession, current war and pending wars, the nuclear threat, climatic disasters and global warming, insurrection and the Q-party, worldwide decline of liberal democracies, record wealth inequality, decreased workforce participation, crop failures and aging populations, I'm feeling pretty good about the economy, really.

[ChpBstrd]

Jamie Diamond (JP Morgan's CEO) predicts recession in 2023.  I think markets overreacted to that news yesterday, falling on bearish rumors.

The S&P 500 recently fell near its 52 week low, which has happened before in June and September.  Both prior times, the S&P 500 bounced upwards off that low as buyers entered the market.  The volatility index seems to bounce between $20 and $35 in this market, and almost hit $34 earlier today.  Volatility looks like it has room to fall.

Finally, CNN's fear & greed index shows a value near 20 (extreme fear), which tends to be on the lower side (but not a maximum value).
https://edition.cnn.com/markets/fear-and-greed

On Thursday we get CPI-U data for September.  Many CPI-U prints have been higher than expected, which I think will cause investors to overestimate inflation.  Multiple professional investors have mentioned softening (lower) inflation, which I think is the most likely scenario: CPI-U lower than expected.  I expect markets to go higher Thursday morning.

I agree that anything better than terrible will lead to a relief rally, and I closed some net-short positions today. Keep in mind PPI will be reported first thing tomorrow morning (Wed, 10/12).
https://fred.stlouisfed.org/releases/calendar

I think PPI will be down significantly (consensus PPI is ~266, which would be 12.9% ttm) due to falling commodity and energy prices in September, and continued improvement in the function of supply lines. This will generate optimism about CPI, which also has a good chance of delivering a positive surprise - unless as I noted earlier, retailers are finally hiking prices in response to PPI being greater than CPI for a while now.

If CPI, and particularly Core-CPI, show signs of moderation, then traders will start to think about a 0.5% rate hike in November, if not 0.25%. The FOMC was no doubt shaken by recent liquidity issues in the UK gilt market, which is just one of several places where liquidity could dry up unexpectedly and cause a cascading effect. If inflation is no longer accelerating, now may seem like a prudent time to take a pause before something big breaks.

The chorus for taking a pause (i.e. the experiment I described earlier) is growing louder. For the past 3 months, CPI has actually been flat - in the range of 295.271 to 295.620 per FRED's default indexing - and by comparison the September 2021 CPI was a full 1.122 index points higher than August 2021. Thus if CPI only gains a fraction of a point, like in previous months, the headline annualized rate of inflation will fall. Given what happened with commodities, we could see another fall in the CPI like what happened in July. The headlines might not say it, but traders will be thinking "Inflation is falling, rate hikes are done, the recession is here, and the bottom is in!"

PCE is telling the same tale, and reinforcing the idea that the Fed just surpassed the "neutral" rate with September's rate hike. If we are now in "restrictive" territory, the FOMC can just wait for inflation to slowly fall, and not trigger any more financial chaos than strictly necessary to reduce inflation.

Recall that from the July CPI release until mid-August, we had about a 13% rally in the S&P500. It could happen again and the rate hikes really could be done. There is no FOMC meeting this month, so traders have time to make a bold play.

So we have to ask ourselves if the S&P500 is a good enough deal at a PE near 18, and a forward PE (for what it's worth before a recession) of 15.2? We have to compare the stock market's 5.5% earnings yield against corporate bonds, with many A and BBB names yielding 7-8% right now in the longer durations, like Mylan, National Health Investors, Reynolds Tobacco, Paramount, Vitaris, Credit Suisse, Blackstone, Dell, General Motors, Altria, Jeffries Financial, Energy Transfer Partners, and Triton. There are also preferred stocks yielding 6-9% from banks, REITs, and non-financials.

The only reason NOT to back up the truck right now is the possibility that everything is about to get much cheaper as some derivative market seizes up, some large bank reveals huge losses on mortgages and bonds, the swaps market freezes, a sovereign country nears default risk, or the FOMC's next press release says "full speed ahead and damn the torpedoes!" That's a very good reason - but the bottom will not pass without there being very good reasons to stay out.

Rather than actually trying to time the bottom, I am considering long calls as a substitute for a stock allocation. If this week's inflation numbers flatline again, I might spend 5% of my un-allocated portfolio buying calls that expire in 10-12 months. That would limit my exposure to losses while protecting against the market running away without me. If I sell these calls in six months, the overall damage would be minimal in the grand scheme of things, compared to the risk avoided. For example, maybe I'm risking a 5% loss to my stock allocation from time decay, but I'm avoiding the risk of potentially having to buy stocks at 15% higher. Is it expensive to buy calls with the VIX at about 34? YES! But sometimes things are expensive because they are valuable. The ability to hold calls, rather than shares, through a foreseeable recession is valuable.

Meanwhile, the fixed income market is what's really exciting. If inflation is actually 2-3% in 2-5 years as markets expect, then a portfolio of those IG bonds purchased at today's 7-8% yields will virtually guarantee a 5% withdraw rate because that's the gap! When rates are cut and financial conditions start to clear, bonds' value will go up as fast as they went down. If the SHTF tomorrow, I'd be watching bonds and preferreds as closely as common stocks, because such are the times when retirement-checkmate-in-one-move opportunities arise.

We're not there yet - maybe not even close. VIX hasn't even crossed 40 in this slow-burn bear market. But I think the opportunity is approaching. 80% bonds, 20% long-duration call options would be a great place to be at the point of peak pessimism.

[Paper Chaser]

The only reason NOT to back up the truck right now is the possibility that everything is about to get much cheaper as some derivative market seizes up, some large bank reveals huge losses on mortgages and bonds, the swaps market freezes, a sovereign country nears default risk, or the FOMC's next press release says "full speed ahead and damn the torpedoes!" That's a very good reason - but the bottom will not pass without there being very good reasons to stay out.

This is just one guy within the Fed, and it doesn't specifically say "damn the torpedoes", but it doesn't sound like they're planning on deviating from the plan anytime soon either:

https://www.federalreserve.gov/newsevents/speech/waller20221006a.htm

Some applicable excerpts:

"Since I last spoke about the economic outlook on September 9, we have received two important pieces of data on inflation for August, consumer price index (CPI) and the price index for personal consumption expenditures (PCE).2 Both reports confirmed that overall inflation remained much too high in August. Though gasoline prices fell, which was very welcome news for consumers, food prices increased notably. Core PCE inflation, which strips out the volatile categories of food and energy, moved up to 0.6 percent for the month, which implies an annualized rate of inflation of about 7 percent in core goods and services. Furthermore, core PCE inflation is not only high, but very persistent, with monthly prints of core PCE inflation at an annualized rate averaging about 5 percent this year. These numbers indicate that inflation is far from the FOMC's goal and not likely to fall quickly.

This is not the inflation outcome I am looking for to support a slower pace of rate hikes or a lower terminal policy rate than projected in the September 2022 SEP. And, though there are additional data to come, in my view, we haven't yet made meaningful progress on inflation and until that progress is both meaningful and persistent, I support continued rate increases, along with ongoing reductions in the Fed's balance sheet, to help restrain aggregate demand. As far as achieving our dual mandate, this is a one-sided battle. We currently do not face a tradeoff between our employment objective and our inflation objective, so monetary policy can and must be used aggressively to bring down inflation.

Let me turn to the troubling persistence of inflation. In the past couple of inflation reports, housing services has been a major contributor to measured inflation. In the latest inflation reports, shelter prices rose 0.7 percent on a monthly basis. Housing has a large weight in price indexes, as households spend a sizable amount of their incomes on housing services. The combination of high monthly inflation and a large weight in measuring overall prices means that shelter inflation is a key driver of overall inflation. Moreover, shelter inflation is a particularly persistent component of inflation and why I am focused on closely watching shelter inflation in determining my outlook for U.S. inflation. Unfortunately, the message is that shelter inflation will likely remain high for several months, meaning overall core PCE inflation will continue to be persistently high."

"As we think about policy actions for the remainder of the year, one can look at the Summary of Economic Projections released by the FOMC at our meeting last month. These projections showed participants expected an additional 100 to 125 basis points of tightening by the end of the year, which means either a couple of 50 basis point hikes at our remaining two meetings, or 75 basis points in November and 50 basis points in December. Of course, the exact path for policy will depend on the data we receive between now and the end of the year.

Before the next meeting on November 1–2, there is not going to be a lot of new data to cause a big adjustment to how I see inflation, employment, and the rest of the economy holding up. We will get September payroll employment data tomorrow, and CPI and PCE inflation reports later this month. I don't think that this extent of data is likely to be sufficient to significantly alter my view of the economy, and I expect most policymakers will feel the same way. I imagine we will have a very thoughtful discussion about the pace of tightening at our next meeting.

So, as of today, I believe the stance of monetary policy is slightly restrictive, and we are starting to see some adjustment to excess demand in interest-sensitive sectors like housing. But more needs to be done to bring inflation down meaningfully and persistently. I anticipate additional rate hikes into early next year, and I will be watching the data carefully to decide the appropriate pace of tightening as we continue to move into more restrictive territory."

[MustacheAndaHalf]

Rather than actually trying to time the bottom, I am considering long calls as a substitute for a stock allocation. If this week's inflation numbers flatline again, I might spend 5% of my un-allocated portfolio buying calls that expire in 10-12 months.
...
We're not there yet - maybe not even close. VIX hasn't even crossed 40 in this slow-burn bear market. But I think the opportunity is approaching. 80% bonds, 20% long-duration call options would be a great place to be at the point of peak pessimism.

I had two reasons to sell all my put options, one of which serves as a warning for your plan.  First, the S&P 500 neared its 52 week low, and I expect the data will give markets optimism.  Second, the VIX is also near its peak, which makes time value of options worth more.  So I also sold to cash in on that peak VIX.

If the S&P 500 goes nowhere, but the VIX falls from 34 to 25, call options lose value.  If we get a rally, that rise in the S&P 500 tends to calm volatility and cause the VIX to fall.  I'd rather not have both of those factors working against me.

I'm considering UPRO and TQQQ, which are 3x ETFs with exposure to S&P 500 and Nasdaq 100.  If markets don't lift off from here, we could see volatility hurt these ETFs more than non-leveraged ones.  They also use swap agreements, which aren't free, and I expect costs have gone up this year.  But if the VIX falls, these ETFs are not impacted, which is a big benefit to them over options.

Good point about PPI release - it will be interesting to see how markets react Wednesday compared to Thursday.

[ChpBstrd]

@MustacheAndaHalf With a leveraged fund like UPRO or TQQQ, you'll still pay for volatility drag. The swaps market has a volatility premium just like the options market. Otherwise, there would be an unarbitraged opportunity between swaps and options.

Yet you're right about the paradox of volatility and calls / protective puts. These tools cost the most at the times when you need them most, and they lose value most quickly as things go well. Imagine the seller's perspective; how would you like to sell unlimited liabilities in volatile times?

However I'm starting to think hedges are not the proper place to be cost-conscious. Even very expensive options offer one the opportunity for unlimited upside and limited downside, at a cost that is a small fraction of one's portfolio. If you want that unlimited-upside/limited-downside return function during sketchy times, you'll have to pay up one way or the other.

In times like this we're trying to grab double-digit gains and avoid double-digit losses, not fret over an extra 1-2% lost on time decay. We cannot know if we've already passed the bottom, or if we're in for another 2-3 years of bear markets, so I'm attracted to the strategy of "losing" relatively small amounts on a rolling series of calls as we go down, until I "win" by essentially buying the right to pay prices near the bottom. We have to keep in mind that this bear market is only 10 months old, and we may be at the equivalent of late-2000 or mid-2008. Likewise, we may have already seen the dip we'll get from a series of interest rate hikes that is nearing its terminal point, as in 2018. For a price, we can hedge our own uncertainty, not expose ourselves to undue risk during risky times, and - most importantly - ensure the market doesn't run off without us.

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

The Producer Price Index came in at 0.4% for September, versus 0.1% expectations. Both goods and services rose 0.4%. Core PPI rose at 0.3%. The annual rise dropped from 8.7% to 8.5%.
https://fred.stlouisfed.org/series/PPIFIS

I consider this BAD. I was expecting a slight decline based on commodities and supply chains, not +0.4%. Basically everything was going well for PPI to fall - oil down, commodity indices down - and yet we still got a decent rise. What happens when OPEC's production cuts send oil prices back up this fall and winter? What about how commodities have been rising quickly since the start of this month (the GSCI is up 7.4% since 9/30)?

It's also an omen that CPI might exceed forecasts tomorrow.

I impulsively bought 900 shares of SQQQ in the pre-market this morning for 62.41. If I'm not up by this afternoon, I'll sell covered calls for some very rich premium and hold the shares overnight. So far I'm up 1.4% - another example of how making an early morning trade based on inflation data compared to expectations can be profitable. There's a strange time lag for the market to digest new inflation info.

Yet it appears at least some market participants are perceiving this news according to the narrative I described yesterday: that inflationary pressures have flatlined. 0.4% is only 4.8% annualized, after all, and is also not so bad when paired alongside August's -0.2% decline in PPI.

The aggressive (maybe bluffing?) and specific Fed language pointed out by @Paper Chaser could quickly give way to more use of the word "data dependency" and a 0.50% hike in November. However at least some market participants are not buying it. According to the FedWatch tool, the odds of a 0.75% hike increased 4.7% since yesterday (and those odds have risen since I refreshed my screen):
https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

[MustacheAndaHalf]

Unlike call options, swap agreements have no time value.  UPRO has stock and swap agreements that equal 300% of the S&P 500.  Every day, large banks pay UPRO the return of the S&P 500, and UPRO pays those banks the interest rate agreed to in the swap agreement.  The bank gets a fixed rate of return (varying with inflation), and UPRO gets leveraged returns of the S&P 500.  But there's no time value, and no way to compare with the time value of call options.

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

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

Note the call option costs $120/sh, but gives the returns of the SPY at $356/sh, so it provides roughly the same 3x leverage as UPRO.  I expect lower volatility, with the VIX falling and SPY rising.  If that happens, UPRO should outperform the call option.  So we can check back next week and see what happened.

[Mr. Green]

Today's CPI report:

8.2% overall CPI
0.4% overall one month rise
0.8% all food one month rise (11.2% annualized)
0.6% less food and energy one month rise (6.6% annualized)

Are we surprised? I would think this all but assures a hike of 0.75 basis points in November.

[EscapeVelocity2020]

Today's CPI report:

8.2% overall CPI
0.4% overall one month rise
0.8% all food one month rise (11.2% annualized)
0.6% less food and energy one month rise (6.6% annualized)

Are we surprised? I would think this all but assures a hike of 0.75 basis points in November.

I'm only surprised that the market is surprised.  I think the question for November now becomes, do we get a 100 bp hike Nov 2nd or an interim hike before December 14th?  Probability of the end of year Fed Rate of 450 - 475 has now overtaken the long held line that 450 would be the tippy top rate...  Waiting until December for another 75 bp hike does not correlate well with 'the risk of doing too little is worse than doing too much', especially given the hot numbers that keep coming in (strong labor market, etc.).

https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html is showing 75 bp hike for Nov at ~98% probability, 100 bp hike has some probability, but still very small.  Fun times!

[ChpBstrd]

I think you're right @Mr Green. More importantly, the futures market now thinks there is a 0% chance of a 0.5% hike, and they've opened up a 2% chance of a 1% hike. The most probable outcome this summer, according to the futures is an FFR range of 4.75%-5%.

The rise of Core CPI to 6.6% - foreshadowed in the Core PPI a day before - means we are still potentially in stimulative territory. I'm kicking myself for not taking the hint and piling into SQQQ. At least I made a couple thousand or about 7% on my SQQQ covered call with 900 shares - might roll it up. There was no time delay in the pre-market this morning! In past weeks, the S&P/Nasdaq have continued to slip for days after the bad news was revealed, so at the open I might play with covered calls on short funds to exploit the past volatility.
 
@Mr. Green Also there's something about your username that makes it impossible to actually tag you in a comment so that your "who quoted your posts" function works - the period followed by the space perhaps?

[Mr. Green]

@ChpBstrd it is indeed the period. Something I didn't know at the time I made the handle. Though a space drops the prefilled list as well. Though if you type out my username exactly with the @ it will still tag me, as I see you've likely figured out. I've debated fixing it but after 8 years have become accustomed to seeing it the way it is.

[MustacheAndaHalf]

Shortly after 8:30 am today, I had lost a nice sum of money.  But then the market started to climb, just slightly, and I started buying in the pre-market.  I finished buying later, increasing my market exposure to 2/3rds (so in a 3% gain, my overall portfolio will rise 2%).

The market expected 8.1% to 8.2% CPI, which wasn't a surprise.  The 6.6% core surprised, but that surprise quickly turned into a small rally (so far).  Where the S&P 500 was -2% soon after the CPI print, it is now +0.66% and rising.

[EscapeVelocity2020]

Yeah M1.5, the market desperately wanted to rally yesterday and today, so I think now that the unknown is out of the way without being absolutely devastating, we'll see a bit of an upswing.  The ball is back in the Fed's court to try to tamp down enthusiasm (and the associated inflation).  This is why I'm not a trader, you have to try to outguess the market participants and the timing of reversals, not the underlying facts.  Longer term, the bottom is not yet in...  I think earnings season will be full of landmines.