‘All That Matters’

A raft of data and a dash of Fedspeak should help traders refine the macro narrative in the week ahead.

Rates caught between increasingly shrill recession calls and scorching-hot inflation will pivot around Thursday’s critical personal income and spending report for May, and the accompanying PCE price data. It might not be pretty. May’s CPI report was very disconcerting and retail sales fell last month for the first time since December.

A downward revision to longer-term inflation expectations on University of Michigan sentiment for June was widely credited with fueling Friday’s rally on Wall Street, but 3.1% (the final print for this month) still isn’t comfortable. And the downshift from the initial reading (3.3%) was likely the result of a 10-day slide in gas prices.

Recall that the preliminary print on long run inflation expectations in the Michigan survey (represented by the red dot in the figure, below) came just hours after May’s CPI report. Some observers suggested the hot read on consumer expectations was just as important as May’s consumer price data in cajoling the Fed into the largest rate hike since 1994. In the context of the downwardly-revised figure, a cooler-than-expected read on PCE prices this week could find traders stitching together a new “peak inflation” narrative.

With the caveat that markets pull forward expected future outcomes, it’s far too early to claim inflation has peaked. As of June 26, AAA gas prices were 10 cents lower versus the prior week, but 30 cents higher compared to a month ago, and $1.80 higher versus this time last year. Oil prices are lower, but they’re still triple-digits.

That’s not to say markets should totally ignore early evidence that the worst may be over. It’s just to suggest that if the past year has taught us anything, it’s that calling the top on inflation, like calling any other top (or bottom, for that matter) is a fool’s errand.

Still, it’s encouraging that market-based measures of expectations have receded. Commodity prices are likewise turning lower (figure below).

If you’re inclined to find solace in that, I won’t dissuade you. “It seems analysts and pundits today are trying to compare the present to the past in the hopes of predicting the future. As anyone who has ever managed risk will tell you, it works about half the time if you’re lucky,” Bloomberg’s Vincent Cignarella, who was keen to remind his colleagues that he, at least, was trading in the 70s. “This inflation is nothing like what prices were like in the 1970s [and] as a result, the selloff in stocks and bonds and the pricing of accelerated Fed rate hikes is likely overdone,” he added, noting that on a quarterly basis, inflation is “nowhere close to inflation of 50 years ago.”

Nevertheless, the Fed is spooked. And, as BMO’s Ian Lyngen and Ben Jeffery noted, policy rates in the US will be at last cycle’s terminal rate by the end of next month. What that means for the economy is anyone’s guess. And there are no shortage of guesses. Many of them are now skewed towards a recessionary outcome.

“Inflation is high, unemployment is low, however real GDP expectations both domestically and abroad are quickly coming under pressure with recessionary fears far more topical than one might have assumed as recently as the June FOMC meeting during which 75bps was deemed the most prudent path for policy rates in light of the balance of risks,” Lyngen and Jeffery went on to say, adding that they’re inclined to think the highs could be in for US rates.

The figure (above) shows the evolution of two- and 10-year yields around the June FOMC meeting. “It’s been quite the wild ride across markets,” TD’s Priya Misra wrote, describing the oscillations shown in the figure. “The market has begun to price in two-sided risks to the economy… whipsaw[ing] between fears of high inflation leading the Fed to hike all the way to 4%, and fears of a growth slowdown resulting in those hikes been pared back and cuts being priced in.”

If there’s one thing everyone agrees on, it’s that until the readily apparent deceleration in the domestic economy becomes dramatic enough to make a recession the base case, the Fed is effectively pursuing a single mandate. “The inflation war is the battle du jour for the Fed and nothing else matters,” BMO’s Margaret Kerins said. “All that matters is inflation” for front-end rates, Misra remarked.

In addition to the PCE data, markets will be treated to durable goods, Conference Board confidence, pending home sales, house prices, second-tier regional Fed surveys and ISM manufacturing in the week ahead. Fed speakers include Bullard, as well as Powell and Mester in Sintra. That, in turn, suggests no relief from the hawkish banter.