This week we saw US consumer price inflation hit 9.1%, rising not only above expectations but reaching the highest seen in over 40 years.
The Federal Reserve (Fed) has been accelerating its interest rate increases and the market moved to price in the possibility of an even larger 1% rise at their July meeting. However, the existing tightening and the expectations of further tightening have already lowered inflation expectations. The ten-year breakeven inflation rate, the inflation rate predicted by inflation-protected treasuries, has fallen from over 3% in April back to 2.35% today. It is important to remember that the published inflation is what has happened, and the Fed may be pushed into overreacting to historic data to battle future inflation, a battle they may already be starting to win. The consequences of that would be a recession and the prospect of the Fed having to start to cut rates as soon as next year.
The US Treasury market moved this week to reflect that view, with two-year bonds accounting for rate rises at 3.10% but ten-year bonds yielding just 2.92% reflecting lower longer-term yields. This yield curve inversion has historically preceded a recession. However, this in itself does not cause a recession. That may be avoided.
Inflation has been driven by supply chain constraints, the sanctions on Russia and a post-pandemic recovery in demand. While interest rate rises can slow demand, they do nothing for the supply side of the equation. There are signs that interest rate rises combined with prices rising faster than wages are already constraining demand. Ever steeper rises will further constrain demand. It is possible that supply is increasing at a time when demand is slowing, reversing the dynamics that have been driving inflation higher.
General Motors already has 95,000 new cars in storage waiting for electronic chips, the production of which has been increasing. Post-pandemic shipping costs soared with Chinese ports closed and containers in the wrong places. The benchmark rate for a 40ft container from Shanghai to Los Angeles rose from $2,000 pre-pandemic to peak at $14,000 late last year but has come back in the last three months to $9,000 despite energy costs rising sharply. President Biden is visiting the Middle East to encourage increased oil production to offset Russian supply cuts. The WTI Oil price has pulled back from a high of $120 to $96 a barrel as I write. US December Wheat futures rose 60% after the Russian invasion of Ukraine but have come back down to near pre-invasion levels today. There is talk of getting a safe corridor through the Black Sea for Ukrainian grain exports. Many of these adjustments are yet to feed through to the US inflation calculation. With the Fed tightening faster than other central banks, the dollar has been strong with the euro at parity and the pound falling below 1.20. This further reduces inflationary pressures for US imports. However, with many commodities priced in US dollars, this will have the opposite effect for other parts of the world.
With unemployment low, workers demand pay increases to match inflation with little fear of losing their job. Therefore in an effort to contain inflation, the Fed may welcome a short-term shallow recession, paired with a rise in unemployment. However, they have a dual objective of stable prices and full employment, so it is possible they would look to slow rate rises if unemployment looks like it is rising too fast. The Bank of England and the European Central Bank are faced with similarly rising inflation, exacerbated by weaker currencies which will no doubt apply additional pressure to tighten faster. Central banks were given independence so that they could make decisions based on economic factors rather than political ones. However, if a central banker engineers a recession to fight inflation, politicians may come to question their decisions. This may become more of a talking point as we approach the US mid-term elections in November. Donald Trump is rumoured to be going to launch his 2024 election campaign before then and he was highly critical of the Fed in the past, urging more rate cuts.
While interest rates were low, it was often said there was no alternative to equities. With bond yields now substantially higher, there are many opportunities opening up in the bond market. Credit spreads have widened as the market fears a recession, further expanding the choice. Spreads may move wider if recession fears become more imbedded but in that case interest rates may not rise as fast, supporting US Treasuries. Given the falls we have already seen in equity markets, they may be pricing in a recession already. For investors, we suggest a selective approach focusing on quality balance sheets. Pricing power will remain key to taking a selective approach.
 Source: Bloomberg
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