How quickly the narrative changes when it comes to the markets. A week ago, inflation was skyrocketing, interest rates were soaring, and the mood was gloomy regarding risk assets. This week it’s as if things flipped 180 degrees. Rising recession risks combined with lower commodity prices is feeding the growing belief that inflation has peaked. This is leading to the idea of the so called ‘Fed pivot’ by year-end. This is just a fancy way of saying the Fed would quit hiking rates and actually contemplate easing if job losses are picking up too much by year-end. Risk assets loved this narrative – at least for this week.
How credible is the idea that inflation has peaked? No one can be quite sure. Certainly, commodity prices have crumpled. Just look at the prices for corn, wheat, and soybeans below.
Obviously, nothing has changed in Ukraine, but sentiment has surely shifted. If you look at the broad commodity indexes, the year-over-year change in the CRB Spot Raw Industrials index has fallen from over +40% growth to just +2.8%.
And if you look outside of commodities, car prices are also coming off the boil. The six-month rate of change in used cars is now negative for the first time since March 2020.
Finally, inflation expectations priced into the bond market have softened noticeably. In late April the market was pricing in inflation of more than 3%. Today that has fallen to roughly 2.5%.
Of course, market expectations can be out-to-lunch, but if you are wondering why stocks spiked and bond yields fell this week, you have to look no further than changes in inflation expectations.
It’s Not the Data Itself, It’s What it Means For Policy
It’s worth reiterating again, it’s not so much the inflation data itself that’s driving the markets, but the perfection of what it means for policy going forward. This week the view on Fed policy softened noticeably. First, short-term bond yields fell by the most since the COVID crisis started in early 2020, as you can see below.
Short-term bond yields reflect the path of expected Fed policy. So, falling 2-year yields should equal more dovish expectations for Fed hikes.
And this is what we are seeing. By week’s end Fed funds futures are suggesting a max policy rate for this cycle of 3.55% versus the Fed’s own projection of 3.75%. This may not sound like much, but for the first time in a long-time investors are now undershooting what the Committee is signaling will be delivered.
Looking further out, only a couple weeks ago the market was pricing in a quarter-point hike at the February 2023 meeting. Now it’s basically pricing in no move. Again, not a huge shift, but it adds to the growing view that rate hikes after the September meeting are growing more and more unlikely.
Of course, all of this could be way off base and the narrative will flip another 180 degrees by July. But it builds on our idea from last week that growing signs of economic weakness in the second half of this year should pressure inflation lower based on everything we know at the moment.
Charts We Found Interesting
1. Another commodity that has been hammered the last few weeks – cotton prices are off almost -30% from the high.
2. Of course, there is a psychological aspect to the rally – sentiment levels are very bearish, and this often leads towards counter trend moves.
3. Interesting chart on small-cap valuations – back to the 2020 low and the lowest level in many years. Note: the valuation metric is only for profitable companies – over 40% of the Russell 2000 components have lost money in the last twelve months!!
4. The labor market is likely to weaken in the second half of the year. 10% of firms in the Philly Fed survey now expect to cut headcounts – only 20% expect to increase employment.
5. There’s no stopping the ETF market – there are now 10K ETFs with close to $10 trillion in assets.
6. The Tesla Model Y and the Model 3 have been named the “most American-made” vehicles in the United States by Cars.com. The study takes into account: Manufacturing location of the vehicle; Manufacturing location of parts; American jobs created by its production. GM didn’t make the top ten (the Vette came in at #11).
7. China’s planned growth in wind and solar power this year is larger than most countries entire installed capacity.
8. Finally, there is the obligatory discloser tied to this chart – correlation does not imply causation!!
Have a good weekend.
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