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Analysis | Curb Your Enthusiasm on the Good Inflation News

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It’s a pleasant change. The headline US inflation number for July came in at 8.5%, lower than the 9.1% registered in June and also lower than virtually any analysts had forecast. A succession of surprisingly strong numbers as prices continued to rise and inflation pressures broadened has at last been interrupted. It’s reasonable to think that the peak for headline inflation — including food and fuel and everything else — is behind us.

However, even if the peak has been scaled, the issue of the descent now confronts us. And it will be difficult. Although undeniably positive, this consumer price index report is not a big game-changer, and it’s unlikely to have much impact on how the Federal Reserve behaves for the rest of the year. 

Here are the key points as I see them:

Transitory Inflation Really Is Transitory

The eye-catching surges in various products that were most directly affected by the pandemic have at last worked their way through the system. Prices for fuel, used cars and rental cars, and airfares all saw immense volatility in the pandemic’s wake, and this was exacerbated by decisions to cut inventory. Now, the surge in prices is more than 12 months ago. Rental-car inflation, at one point more than 100%, is now negative. Used-car inflation is down into single digits. Fuel and airfares remain elevated, but below their highs. There’s every reason to expect these inflation numbers also to continue improving:

With the exception of fuel, these are all included in the standard measure of “core” inflation, which enjoyed its lowest monthly rise since last September. However, there is now a sense in which the transitory effects are beginning to make that core measure look lower than it really is, after months of making it look higher. In this chart from Steven Englander of Standard Chartered PLC, the green line shows an “adjusted core” excluding the most directly pandemic-affected items. It also reduced last month, but at this point, the transitory effects are flattering the overall core numbers:

The Measures the Fed Cares Most About

The problem is that most of those extreme price moves had nothing to do with monetary policy, and there was little the Fed could do to control them. That isn’t true of most products. Different research groups within the Fed monitor measures of a “core” of inflation to look at underlying price pressures, and these are still rising. It’s possible that we’re at or near the peak, but we haven’t passed it.

Two widely followed measures come from the Cleveland Fed, which publishes a trimmed mean (excluding the biggest outliers in either direction and taking the average) and the median. These measures were never moved by rental cars or gasoline in the first place. And unfortunately, both continued to rise, and both are at their highest since the series started in 1984:

Narrowing down to look at the month-on-month change, however, it’s good to see that July’s increase in the trimmed mean was the lowest since last August:

The Atlanta Fed monitors prices that are “sticky” (which require lengthy planning to change and are hard to reduce), against flexible prices that can rise or fall swiftly with little difficulty. The early months of the inflation scare were dominated by flexible prices, for which inflation is beginning to drop a little. What matters for the Fed is whether expectations have become so dislodged that sticky prices are moving. And again, the year-on-year rate of sticky price inflation rose last month, to a new 40-year high. This is a big problem that implies a need for extreme central bank vigilance. The good news is that sticky prices didn’t inflate as much last month as they did the month before — but this is still strong evidence that as far as the Fed is concerned, the peak is not yet in:

Then there is the critical issue of housing costs, which account for about a third of the entire index. Year-on-year inflation in owner-equivalent rent, which aims to capture changes in accommodation costs for renters and buyers, rose again last month to set a new high since 1990. This number tends to come through with a lag; despite signs that the big increase in borrowing costs driven by the Fed’s tightening to date is already having an effect on the housing market, the number is likely to keep rising — and take core inflation up with it. 

What’s the Fed Got To Do About It?

On balance, this doesn’t change things much, although the avoidance of yet another negative surprise means we can rule out any risk of a “shock-and-awe” move, such as a hike announced between Federal Open Market Committee meetings of a 100-basis-points hike in September. As far as the fed funds futures market is concerned, as measured by Bloomberg’s own World Interest Rate Probabilities function (WIRP on the terminal), the surprisingly strong payroll number from last Friday and today’s encouraging inflation data have almost exactly canceled each other out. The chart shows the number of expected 25-basis-points hikes in September, so 2.00 equals certainty of 50 basis points, and 3.00 means certainty of 75 basis points. The fed funds market seems to be saying that the Fed could equally easily go with either, and it’s probably right about that:

As for the Treasury market, by the end of the day’s trading it was surprising how muted the reaction had been. The two-year yield did dip a bit, so the yield curve became a little less inverted, but looking at the progress of two- and 10-year yields in a dramatic year, it’s plain that the bond market isn’t treating these numbers as a big turning point:

Inflation breakevens dropped slightly, but again treated the news as no game-changer. The two-year breakeven, in particular, continues to be influenced at least as much by the oil price as by new inflation data and pronouncements from the Fed:

The market most strongly impacted was foreign exchange. The dollar index, comparing the currency against a range of its largest trading partners, had its biggest percentage fall in two months, and the sharp rally of July now seems to be over. That relieves pressure on multinationals’ profits and will be most welcome news for emerging-market finance ministers:

The problem with this is that the Fed would like financial conditions to stay tight. Put lower bond yields together with a weakening currency and rallying equities, and you get a substantial easing in overall conditions, which is exactly what the central bank doesn’t want if it’s to reduce demand and keep a lid on inflation. There are different ways to aggregate financial conditions, but both Bloomberg’s own index and a counterpart kept by Goldman Sachs agree that things are getting much more lenient. In the chart, a rising line indicates looser conditions, while a fall shows a tightening:

Put all this together, and Jerome Powell would probably like the markets to be helping a bit more by making financing a little more expensive. So there’s no case for a dovish pivot as yet, and a pretty good argument to show the markets who’s boss with a 75-basis-points hike next month.

That brings us to the stock market, where Wall Street continues to defy inflation skeptics who think the peak is yet to come after the softer-than-expected CPI print for July. The benchmark S&P 500 gained 2.1% to its highest since May, led by economically sensitive stocks like chipmakers and car manufacturers. The tech-heavy Nasdaq Composite Index rallied 2.8% to extend its gain to almost exactly 20% above its trough for the year, set in June. In some quarters, this has already been proclaimed a new bull market. 

As a result of all this, hopes were raised that this uptrend could confirm that the stock market bottom was hit in June. Working this out is more a matter for gauging crowd behavior and collective action, rather than attempting to prove anything with valuations. A too-expensive market can always get a little more expensive. Rather, at times like this, chart patterns are among the best guides.

Chart analysts agree that the stock market is now close to the point at which it’s safe to say that June was the low. But for some, including Sam Stovall, chief investment strategist at CFRA, the coast isn’t clear until the benchmark index closes above 4,231.66 — a 50% retracement level for the current bear market. It closed Tuesday at 4,210.24, so the S&P only needs to gain less than 1% to get there. Using  Fibonacci analysis, Stovall thinks reaching the midpoint would be a signal that the market is poised to make a full recovery:

“Closing above this level would imply that the bear market low has already been set,” Stovall said, “since none of the earlier 13 bear markets since 1946 enjoyed a 50% retracement of its decline only to endure a subsequent selloff that exceeded the prior low. It doesn’t mean that the prior low won’t be challenged, but it does indicate that the June 16 low will likely hold.”

The table below, compiled by CFRA and published Monday, lists the 19 times since World War II that the S&P 500 entered into a bear market — a drop of 20% from its high — or a correction of 15% to 19.9%:

Recent history shows that the 50% retracement test worked for all but one. Only the bear market of 1973-1974 recorded a lower low following the 50% retracement of its 15%+ decline. And even that was due to an exceptional geopolitical shock. The Yom Kippur War, in which Arab nations invaded Israel in a conflict that led to an oil embargo, broke out just after the S&P had achieved its 50% retracement. After that, it suffered a disastrous 44% fall. 

For some technical analysts, though, the level to watch is 4,177. This is where the S&P 500 marked the peak during its May to June rebound. Chartists refer to this as a “higher high,” as explained in  this piece by Lu Yang and Isabelle Lee. This, they pointed out, is supposedly a signal that more sustained gains are in store.

The point of agreement appears to be that if the market moves much further upward, it will be much safer to assume that June was the bottom. That still leaves open the question of how far the market can go from here. That depends in large part on the economic fundamentals. Strategists have differing opinions on where equities will travel. For Seema Shah, chief global strategist at Principal Global Investors, this is nothing but a textbook bear market rally:

“Technicals and sentiment drove the upturn and momentum is carrying it for now. Markets have become overly optimistic about the Fed outlook and even the economy. But as we get into Q4, earnings growth will show clear signs of struggles and inflation will be easing only slowly, giving markets an important reminder the further rate hikes are absolutely necessary. That should lay the groundwork for renewed market declines.”

Jay Hatfield, founder and chief executive at Infrastructure Capital Advisors, also thinks stocks may retest the June lows especially ahead of September and October, typically volatile months for the market as traders return after the thin volume of the summer.

September’s FOMC meeting will be key moment. The CPI print prompted swaps traders to trim bets on another 75-basis-points rate hike in favor of a 50-basis-points move instead. But the stock market seems more confident about a dovish Fed. Here’s Oliver Blackbourn, multi-asset portfolio manager at Janus Henderson:

“CPI inflation print may cool hawkish sentiment towards the Fed, at least for a while, and the US economy looks less in danger of a serious slump, even before any renewed fiscal stimulus. With the increasingly hawkish Fed having been the main source of concern for the US stock market, any signs of FOMC members becoming more circumspect could lengthen the rally there. Similarly, the divide between higher quality companies and value stocks could become more pronounced as recession risk wars with potentially more dovish central bank outcomes in investor decision-making.”

The bullishness, however, should be met with caution. After all, there will be another jobs report and another CPI print, and a conference in Jackson Hole, before the FOMC’s next scheduled session. It may be a bit premature to definitively say equities are out of the woods, because it’s hard to see what can take them further. David Petrosinelli, senior trader at InspereX, weighs in:

“The rally in stocks has gone too far, given the that the Fed has to destroy demand across the board to get inflation under control and I think the equity market either doesn’t fully understand or believe it, or both. S&P is right around 50% retracement at ~4,200 and it seems to me that there are few catalysts to go meaningfully higher from here. Economic news isn’t great, more rate hikes which make it worse and lower savings rates and higher consumer debt all point to meaningful slow down in consumption and, ultimately, investment to me.

So, the charts suggest the bottom might well be in (barring a Yom Kippur War-level shock in the near future). But any sensible analysis of the economy suggests progress will be difficult from here. 

—Assistance by Isabelle Lee

Terrible news from the BBC. Breaking a tradition that stretched back to before the coronation of Queen Elizabeth II, BBC radio is discontinuing its classified football results service on Saturday afternoons. The fact that everyone can just look up all the results on their phone in real time had something to do with the decision, but that’s beside the point. Sports Report started with this great theme tune called “Out of the Blue,” and would then move on to the results, read out in a lyrical cadence by the late James Alexander Gordon. It was poetry. It was a point of stability. Ending it is vandalism. It’s almost as if the BBC were to axe the theme to Desert Island Discs (whose title I now learn is “The Sleepy Lagoon”), which has also been around longer than the queen has been on the throne. Most sacrilegious of all would be to lose Sailing By, the prelude to the late night shipping forecast. The music itself was hypnotic, but the melodic lilt as the announcer read through the forecasts for all the evocatively named shipping areas (North Utsira, South Utsira, Dogger, Rockall, Finisterre, Mallin, Fair Isle and the rest) off the British Isles was wonderful — the perfect way to slide away to sleep. I’ve even found apps designed to improve sleep and reduce stress that will play you the entire BBC shipping forecast.  

It’s  even more incantatory than Goodnight Moon (read here by Susan Sarandon of all people). But soothing though that story is, the tale of its writer and her estate is anything but; if you feel like wading into a beautiful and brilliant piece of narrative journalism from the Wall Street Journal, this could be for you. 

More From Other Writers at Bloomberg Opinion:

• Jonathan Levin: Inflation Surprises Are Bad Even When They’re Good

• Jared Dillian: Latest Meme-Stock War Is Hedge Fund Versus Hedge Fund

• Javier Blas: In the Energy Markets, Putin Is Winning the War

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator and editor of the Lex column at the Financial Times, he is author of “The Fearful Rise of Markets.”

More stories like this are available on bloomberg.com/opinion

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