Feb 21. Inflation/stagflation
Themes:
- Inflation / deflation
- Financial market stress (Cleveland Fed)
- Curve flattening
- Tax withholding slowdown
Looking at a chart of CPI as published by the BLS, it has clearly been on an uptrend for the past year. As Friday’s release said: “CPI for all items unchanged in Jan as energy declines offset array of increases.” Friday’s Core CPI was 2.2%, the highest in 4 ½ years. The data breakdown confirms that energy is the culprit holding inflation down. The Fed’s latest mantra, repeated by Mester Friday, is that “Oil prices cannot continue to decline indefinitely, nor can the dollar continue to appreciate forever.” Quite true. Ian Shepherdson of Pantheon Macro said, “…the dollar is not pushing down goods prices to the extent signaled by past experience, and that is allowing the clear upward trend in services inflation to drive up the aggregate.” So what are the services? Unadjusted 12 months ending January, Shelter +3.2% and Medical Care Services +3.3%.* As we know, prior to the housing bust, home prices relative to income had gotten to record levels. Now of course, rents are growing faster than income, another situation that ‘cannot continue indefinitely’. And the increase in medical care is not exactly reflective of economic strength.
My personal view of inflation/deflation is that deflation risk grows when firms/households cannot service their debts, leading to asset sales and product price cuts, even below costs. The risk of inflation is driven by a spiral of strongly rising wages absent increased productivity, which courses through the entire system. The fact that major retailers are involved in huge cutbacks while shelter and medical care increase in price, makes me lean towards the former scenario. The price action of equities only reinforces this view, as does the decline in market based measures of inflation expectations.
What many analysts do (another echo of the subprime crisis) is measure the percentage of a given problem to determine its impact going forward. For example, Mester went into some detail about China: “Exports to China represent 7 to 8 pct of total US exports and total US exports are about 12 to 13 pct of US GDP. So the direct effect of trade with China on US output is small.” Perhaps the static previous measurements are correct, but the dynamic forward impact is much harder to predict, and that’s where the Fed seems to get things consistently wrong.
In terms of tightening it’s instructive to look at the Cleveland Fed’s Financial Stress Index [chart] which is nearing the peak in 2012. The market is very clearly tightening for the Fed, and I would personally submit that price increases in medical care/insurance only add to that stress.
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Below is a chart of 2/10 treasury spread with the red/gold euro$ pack spread (2nd to 5th year), and the Fed Fund target rate. With Friday’s release of CPI, these curve measures made new lows (100 bps and 83 bps respectively), well below the lows of 2012. While equities rebounded this week, these charts are not meant to give a warm and fuzzy feeling. The flattening is indicative of 1) absolutely no inflation premium and 2) a global economy in a dubious state of disrepair. Or despair.
2/10 is the white line, red/gold pack spread is red, Fed Fund target in blue.
Just a couple of other things to mention about the chart. The circled areas on the far left show inverted curves, or negative levels. That’s when the Fed had just wrapped up its tightening campaign from 2004 to 2006 and the FF target hit 5.25%. We know what happened next. Of course, we are nowhere near negative now but the direction is disconcerting, especially with funds hugging zero. The second thing is that the charts aren’t on the same axis, the highs in both 2/10 and red/gold are both around 300 bps. Another thing to note is that the 2/10 spread is right at the 0.618 retracement of the 2006 low of -19 bps to the Feb 2010 high of 291 bps. This is an area to try to hold.
In short, who are you going to believe? The Fed and other government agencies or the messages from the markets?
One other indicator I would like to highlight is one that I don’t often see information about, federal income and employment tax withholdings. http://www.investors.com/news/economy/tax-withholdings-cast-doubt-on-rosy-fed-jobs-view/
“The broadest and most timely read on the health of the job market has been sinking at an alarming rate”. From the source material website dailyjobsupdate.com : “The data is a simple bean-counting of how much money was collected. It is not estimated, adjusted, or massaged in any way. You are looking at the most precise depiction of the economic cycle ever invented.”
“…for most of 2015 tax withholding rose at a rate of 5% or more from a year ago…revenue inflows to Treasury steadily slowed through the fall, bringing the annual growth rate down to just 4% by the start of 2016. That’s when growth seemingly collapsed – to just 1.8% over the past five-plus weeks, from Jan 11 through Feb 16.” Maybe it’s just a rough patch. But the fact that stocks and the curve are sending warning signals at the same time seems more than coincidental.
Coming up this week:
Stanley Fischer speaks Feb 23 at 8:30 pm EST, Developments in Monetary Policy
Lael Brainard on Feb 26 1:30 pm EST, International Monetary Policy Synchronization
G20 meeting in Shanghai Feb 26/27. Note a new rule from China: Will “…ban all foreign publishers – even those in a local joint venture – from putting content online in the country directly or without prior approval.” (Forbes). So things must be pretty good over there…
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| 2/12/2016 | 2/19/2016 | chg | |
| UST 2Y | 69.4 | 74.2 | 4.8 |
| UST 5Y | 119.9 | 122.6 | 2.7 |
| UST 10Y | 174.5 | 174.8 | 0.3 |
| UST 30Y | 260.2 | 260.7 | 0.5 |
| GERM 2Y | -50.8 | -53.2 | -2.4 |
| GERM 10Y | 26.1 | 20.2 | -5.9 |
| EURO$ M6/M7 | 16.5 | 18.0 | 1.5 |
| EURO$ M7/M8 | 28.0 | 25.0 | -3.0 |
| EUR | 112.56 | 111.31 | -1.25 |
| CRUDE (1st cont) | 31.91 | 31.75 | -0.16 |
| SPX | 1864.78 | 1917.78 | 53.00 |
| VIX | 25.40 | 20.53 | -4.87 |
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http://www.bls.gov/news.release/pdf/cpi.pdf
