As the year winds down the markets are fixating on three things – what happens with the Omicron variant, where inflation is headed, and how aggressive will the Fed be in battling the perceived inflation risks? On the first question opinions differ widely. There’s a chart at the end of this report that shows South Africa’s experience with Omicron to date. More infections but less severe seems to be the headline story, but we shall see.
On the inflation and Fed front we had a nicely timed CPI report today ahead of next week’s Fed meeting. Inflation was hot in November, as expected. Prices were up +0.8% for November and +6.8% year-over-year while core prices (excluding food and energy) were up +0.5% and +4.9% respectively. This was the fastest rate of inflation since 1982!!
As an aide – one of the biggest hit singles of 1982 was Eye of the Tiger by Survivor. Admit it – you can hum the tune whether you like it or not!!
The market’s reaction to the inflation data was pretty tame. Stocks rallied and longer-term bond yields initially dipped. The hot number was expected, and the fact that the month-over-month inflation number (chart below) cooled down a bit calmed some investors. This is especially true given the recent dip in energy prices.
One notable contributor to the inflation reading was the shelter component (roughly a third of the index). As you can see below, it’s bounced back significantly since the COVID lockdown days and is now challenging the highs seen before both the tech and housing busts.
The temptation is to extrapolate the inflation readings out for ever more. But the bond market is sure looking at something different. Take the chart below. Each dot shows the monthly combination of inflation and the yield on the 10-year Treasury since 1991. The months noted are all from 2021.
This is definitely a head scratcher. The bond market is looking at the inflation numbers and yawning. “Markets are crazy/irrational/mispriced” scream the bond bears. But the U.S. bond market is close to $50tn in size and trades upwards of $600bn a day!! You mean to tell me all those investors/traders are irrational? Ummm. Even though Powell has retired the word transitory, the bond market doesn’t look so certain.
Regardless, how will the Fed react to the latest reading? We feel the pressure is now on to do be seen doing something. It’s worth noting that the spread between inflation and the Fed Funds rate is the widest it’s been since the 1940s.
And various Fed members have been sending signals they plan to get more aggressive with policy. Only a few weeks ago the Fed said they would start reducing the size of their asset purchases in December by $15bn a month. That number probably goes higher next week. Per J.P. Morgan:
“At the conclusion of next week’s FOMC meeting we expect the Committee will decide to speed up the pace of tapering to a $30 billion per month reduction in the monthly pace of asset purchases, which would see the conclusion of those purchases in mid-March. For the median interest rate forecast “dot” we think it’s a close call between looking for two or three hikes in ’22, but think three is a little more likely. We are also adjusting our own forecast, now expecting liftoff in June (previously Sept), followed by a quarterly pace of hikes thereafter.”
This is in-line with current market pricing. The chart below shows that the odds of three hikes by December 2022 stand at 29.4%. Four hikes are up to 19.0%.
But higher short-term rates don’t necessarily mean higher long-term rates. The spread between 2-year and 10-year bonds is tightening, something we saw during the last rate hike cycle in 2017/2018. The question going into 2022 will be how flat does the curve get?
Charts We Found Interesting
1. Cases in the U.S. are rising rapidly. Omicron is probably being significantly undercounted.
2. How Omicron is evolving in South Africa. So far more contagious but less virulent.
3. New headlines can be confusing – guess they have to write something.
4. The NASDAQ is in bear-market territory if you strip out the five biggest stocks.
5. Passenger electric vehicles are now 10% of total car sales. And most of those sales are pure battery EV, not plug-in hybrid.
6. Demography is destiny. Anyone under 10-years old in Japan only knows a declining population.
7. China is right behind Japan.
8. But zoom out and the population growth curve is stunning. Someone born in 1960 was born into a world of 3 billion people versus basically 8 billion today. No wonder the TSA lines are awful!!
Have a good weekend.
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