The inflation left-tail risk may be “dying out.”
That was one message from Nomura’s Charlie McElligott who, on Tuesday, suggested some market participants are becoming at least incrementally more comfortable with a version of the “soft landing” narrative, even if “soft” ends up being a relative term.
While it’s eminently possible (indeed, it’s likely) that the US will be compelled to grapple with irritatingly persistent 4%, or even 5%, inflation for much longer than investors expect, the risk of a disorderly spiral atop that witnessed during the first half of 2022, is diminished.
There are three key points. First, there are just enough downside “shockers” (if you will) to suggest that economic activity is cooling rapidly, which in this context is a good thing as long as the labor market holds up and the “hard” data doesn’t roll over such that a real recession (whatever that means to you) becomes the base case. Housing is cooling. Fast. And Monday’s egregious Empire manufacturing print was arguably amenable to a “bad news is good news” interpretation.
At the same time, speculation for the return of Iranian barrels has put more downward pressure on crude prices, which were already falling. Oil’s down almost 9% this month, and nearly 30% from the highs (figure below).
“The simple interpretation is that both the persistent ‘slowdown’ signal in global economic data and, more obviously, the disinflationary pressure from oil’s hard rollover are further easing central bank ‘over-tightening’ fears and cutting the ‘hawkish left-tail’ scenario,” McElligott wrote, adding that oil’s pullback is “reducing a critical source of strain on both consumers and corporates.”
Of course, the slowdown in the Chinese economy is likewise bearish for crude, but there’s more to the China story than that.
Yuan depreciation is inherently deflationary, and with the Fed still leaning into rate hikes while the PBoC eases, traders are increasingly prone to playing for additional weakness. Consider, for example, that on the heels of China’s MLF cut on Monday, dollar-yuan was the most active pair globally in the options market, with standout demand for USD call spreads.
Monday’s drop was the largest since early August 2019, when Beijing let the yuan depreciate past 7 per dollar, effectively weaponizing the currency after Donald Trump abruptly broke a tenuous trade truce struck at the Osaka G20 (figure above).
“The recent rage weakening in the Chinese yuan is contributing an additional disinflationary input to the global economy,” McElligott went on to say Tuesday.
All of the above argues for peak inflation, and set against what, for now anyway, still looks like a bulletproof US labor market, the outlook for some version of a soft landing has improved. “Jobs theoretically provide slack to absorb the Fed’s signaled path to run policy rates restrictive, higher and tighter for longer,” McElligott wrote, before echoing a warning from last week.
The Fed is keenly aware of the extent to which some critics expect a repeat of the mistakes made in the 70s. As such, they’ll be cautious to avoid any such misstep. “This is why my largest ongoing medium-term concern is that an increasingly sanguine market now does not know how to handle a scenario (say in Q1 2023) where inflation remains ‘stuck’ at 4-5%,” McElligott said.
In such a conjuncture, the Fed would be compelled to keeping leaning in, “with the market getting caught flat-footed” against stubbornly high terminal rate pricing, as inflation realities prevent the dots from catching down.
H-Man, so if inflation keeps hanging around, what does it do to the curve inversion? Does the long end push higher to return to a normal slope or does the front end capitulate while the long end holds? Something has to give assuming the curve has to revert to the norm.
are we saying its going to be a deflationary recession with fed pivoting (lower rates & qe coming back)?
No, that’s the opposite of what this says. The suggestion from this article is 4% to 5% persistent inflation with a Fed that can’t pivot decisively.
but why would inflation stick to 4-5%, though? Oil/energy is coming down, home/rent equivalent etc. may stay a bit elevated but come down fast in a few months, US is relatively well protected against food inflation provoked by Russia invasion of Ukraine…
and I still struggle to see a wage price spiral, esp. if job openings get slashed and with hours worked mysteriously weak…
Look at PPI. Costs are still rising and wages that rose in COVID will stay rose [sic]. Look at all the things that go into a lowly box of Raisin Bran: grain (up), sugar, raisins, plastic for bags, cardboard, and fuel (some say 50% of the total cost), among others. Fuel and truckers are needed to get the raw materials to the place where they are processed, then from processing to the cereal factory, from the factory to the distributor, from the distributor to the store or regional warehouse. This chain exists for most of the inputs. Even small rises in these inputs and their chains add up. When costs rise, producers have only two real choices, to raise prices or cut costs. When they lose bargaining power with suppliers (grain markets, fuel markets, etc.) they must try to raise prices to cover the rising costs. When consumers no longer accept higher prices then something has to give. Our last best solution was to go offshore for much of our production. Last year alone we imported $2.8 tril of stuff, in spite of any hype to the contrary. Our standard of living will decline sharply if we don’t maintain our imports. When the PPI starts to fall then I’ll believe in “peak inflation.”
“Our standard of living will decline sharply if we don’t maintain our imports”.
Are you sure?
Absolutely sure. We’ve been moving our production to lower and lower cost places for a hundred years. From New England to the Carolinas, then to Puerto Rico, then to Mexico, China, Thailand, Vietnam, etc. Look at the labels in your clothes and shoes. Deere just move a bunch of stuff to Mexico. Whole industries are gone so we can afford the stuff we want.
The wage-price spiral is already here. I’m not sure what evidence anyone needs for that other than record-high prints on the most important measures of wage and compensation growth. I mean, where do you reckon that comes from? Employers suddenly becoming more generous? There’s an acute shortage or labor, consumer prices are sky-high and the combination of the two is driving wage costs inexorably higher. Those costs are being passed along to consumers in the form of higher prices, and those consumers then need even higher wages to afford the same goods. That’s not a hypothetical. It’s happening right now, as we speak/type. The fact that real wage growth is negative makes the problem worse, in my opinion, as it only creates an even stronger incentive for scarce workers to demand higher pay.
The notion of a wage-price spiral gained credence back in the 60s and 70s when so many compensation packages included automatic COLA kickers. Very few do now. That acts as a barrier against real wages keeping up with CPI. Just a nuance but it may prove critical in the months ahead.