Tunnels, Lights And Trains

There’s a light at the end of the tunnel. (Insert oncoming train joke.)

One argument floating around Friday suggested the prior session’s monumental rally on Wall Street was way too much, way too fast in light of inflation realities, particularly given the possibility that at least some of October’s benign monthly CPI print might not be repeatable.

Another, competing, argument, said that if you put aside the overwrought theatrics in asset prices, the real takeaway from the CPI report was that if anything isn’t repeatable in perpetuity, it’s 30- and 40-year high shelter inflation prints when mortgage rates are the highest in two decades and the housing market is rolling over. If a “naive” overlay chart of lagged shelter CPI gauges with home price indexes was good enough to predict the surge in the former, then why is the same “naive” chart with home prices leading not good enough to predict an eventual drop in the pace of shelter price growth assuming the trajectory of home price appreciation continues to drop precipitously (it may well turn negative)? More simply: Shelter inflation accounted for half of the all-items CPI increase last month. Imagine how benign the report would’ve been without the multi-decade highs on the shelter components.

I’m not taking sides. If anything, I’ve been an alarmist on inflation for the last five or so months, suggesting repeatedly that it might be randomly determined to a greater or lesser degree going forward and that, in the event core were to stay stuck at 6% for, say, six months or a year, it’s not obvious what the Fed could do given that policy rates in excess of 7% (if you assume 100bps above realized inflation in order to bludgeon price growth back to target) could well cause rolling VaR shocks, UK LDI-style, on a fairly regular basis. That’d be a wholly untenable state of affairs. In a prolonged stalemate scenario, risk models would need to adjust to the new policy reality and officials to the new inflation reality, such that policy rates could rise to draconian levels without crashing every asset on the planet, and officials could concede that 3.5% on core might be the best they can do until various structural disinflationary forces reassert themselves.

Having thoroughly buried the lede, let me return, abruptly, to the ostensible light at tunnel’s end. The figures (below, from BofA) show the trajectory of YoY headline and core CPI assuming different MoM outcomes.

Those charts come with the usual caveat: I haven’t run these numbers myself. Plenty of others have, though. You can find various versions of the same charts floating around finance-focused social media. I highlight BofA’s for convenience.

Note that the projections run through June of 2023, when, if the MoM prints were to miraculously print unchanged starting now, inflation would be below the Fed’s target.

Plainly, that’s not going to happen, and to be sure, BofA’s Michael Hartnett adopted a characteristically cautious cadence in editorializing around those and other visuals in this week’s installment of his popular weekly “Flow Show” series.

What I wanted to point out, though, is that if monthly headline and core prints are consistent with October’s figures going forward, headline and core would be 3.8% and 4%, respectively, by June, when, according to market pricing, Fed funds will be ~4.75%. So, 100bps above headline and 75bps above core in that hypothetical.

That wouldn’t be “victory.” After all, 4% CPI isn’t 2%, and 4.75% isn’t either. But, the real policy rate would be positive, quite possibly even more so using PCE instead of CPI. If you assume (and this, I think, is a safe assumption) that NFP will be printing much smaller monthly gains by then, and that job openings will be far lower than they were as of the last JOLTS data (albeit still historically elevated), you absolutely have a case for a Fed pause.

The figure (below) is familiar. It’s Hartnett’s annotated history of Fed funds.

The implication from the chart header is that even at 5%, rates would be below most modern historical Fed pivots.

I’ll grant that (because it’s a fact), but I don’t think that’s the best way to conceptualize of this situation. A funds rate of 5% means something different today, after 12 years of almost uninterrupted accommodation and leverage deployment.

Modern market structure was built atop ZIRP, NIRP and LSAP. When a probability distribution is based on what we can fairly describe as managed outcomes, a sudden return to unfettered price discovery means blowing through risk limits — because the parameters were just an exercise in recency bias.

Of course, one way to engineer disinflation is to stumble into a deflationary bust. If that’s the oncoming train traders mistook for a light at tunnel’s end on Thursday, then we needn’t worry too much about inflation. Introducing a 6% or 7% funds rate into an environment where liquidity is poor across assets, investors are still long a lot of duration in one form or another and models haven’t adjusted fully to a wider distribution of daily outcomes, could well dynamite the building.

As a last resort, I suppose that’s a viable strategy. But you don’t want to do it by accident, which is what might happen if you fail to recognize that, unlike one genuine US dollar, 5% Fed funds goes a lot further these days than it used to.