The Factory Daily Letter
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Is the hot CPI print enough to trigger a 75 basis point rate hike?
Markets want to know that the Fed can get ahead of inflation
Markets and policymakers alike are now navigating the huge challenges presented by the prospect of higher inflation and slowing growth. Today’s FOMC meeting is a key event for investors who will be hanging on every utterance at Jay Powell’s press conference and scrutinising both the post-meeting statement and guidance, as they seek to anticipate the trajectory of monetary policy and take a view on how the same affects the outlook. Markets took fright from last week’s hotter-than-expected US CPI print - that which put a pin in the prevailing narrative that inflationary pressures could have peaked in the US: a May print of 8.6% YoY (vs 8.3% expected and up from April’s 8.3%) put consumer headline inflation at its highest level over the last 40+ years (and while some of the core measures showed some potential signs of slow-down on a year-on-year basis, it also nonetheless rose more than expected on a month-to-month basis).
So, will the Fed up its game as the markets now expect it to?
Until Friday’s CPI print, markets were expecting a 50-basis point rate hike to be announced by the Fed at today’s meeting (as guided). They are now as we write pricing a 75-bps hike with an additional 125-bps in July and September (with some talk of a 100-bp hike having even crept into the narrative) and expect the Fed fund rate to rise to around 3.6% by year-end (with more than 11 additional 25 bps rate hikes priced in for the rest of 2022). The so-called “dot plot” - Fed officials’ projections for the Fed funds rates that is updated quarterly - will also be revealed.
The initial scenario of our economists here at Pictet was that we would most likely see two more 50 bps rate hikes from the Fed (one announced today and one in July) before policymakers would pause the tightening cycle over the summer (to take stock on the delayed effects that policy may have had on economic conditions). However, this recent hotter inflation print has certainly changed the market view and our economists agree the likelihood of a 75-bps hike being announced at this meeting has significantly risen (with the risk of a pause over the summer diminished). Overall, the risk of further tightening remains tilted to the upside.
Markets are both worried and impatient
This significant upward repricing of Fed hikes sparked a sharp sell-off on Monday (on the risk that the Fed will have to be more aggressive to combat inflation but thereby put growth at risk -stagflation being risky assets’ Achilles heel). The Nasdaq closed the day 4.7% lower and the S&P 500, having fallen more than 20% from its high, dropped into bear market territory. On the bond markets, yields significantly rose on the news with the US 2-year yield briefly rising above that of the US 10-year (3.38% vs 3.35%, respectively), signalling the rising risk of recession.
Dissecting the CPI print: US headline inflation for May continued to edge higher while core measures have shown some potential signs of peaking
Last week’s hotter-than-expected US inflation print (+8.6% YoY vs +8.2% expected, up from prior’s 8.3%) was mainly boosted by rising energy and food prices but also by ongoing bottlenecks, reopening factors and rents. Excluding food and energy prices the core measure rose 0.6% MoM, yet the annual figure fell from 6.2% to 6%.
US core PCE (which is the Fed’s preferred inflation measure) slowed in April compared to March, falling very slightly from 5.2% to 4.9% YoY, yet both headline and core were nonetheless still above estimates, the data release at the end of May already putting the dampeners on the peak-inflation narrative. It was thus perhaps unsurprising that a reading of US CPI at its highest over the last 40 years went on to kill that narrative, and the hot inflation print prompt bets that the Fed would be obliged to be more aggressive in terms of the policy it deploys to manage it.
The main contributors to US CPI annual growth in May were energy prices, hotels and airfares, cars, and rents. Our economists still expect inflation to peak during the summer before gradually easing over the second part of the year, as transitory factors such as energy, hotel and car prices could indeed decline over the months to come. Their 2022 and 2023 annual inflation forecasts are currently 7.6% and 2.6% respectively.
While median broker estimates for Q2 inflation have been revised lower, those for Q3 and Q4 2022 have recently ticked upward
As illustrated in the graph below, while the US broker median estimate for Q2 2022 CPI has come down recently (from around 7.5% to 6.5%), estimates for Q3 and Q4 have started to move upwards: analysts may continue to see a peak in inflation on a year-on-year basis, but they are now considering that it could remain higher over the coming months. For 2023, consensus seem to lie around 2%/2.5%:
While consumer sentiment continues to deteriorate, wage growth remains below inflation
The US consumer has become increasingly concerned about inflation and its diminishing effect on purchasing power, and they have been negotiating higher wages since mid-2021 - in a move that has been supported by the tighter re-opening labour market conditions. However, and as illustrated below, 3-month average median wage growth hit 6.1% in May, while the employment cost index for the private sector has reached around 5%. Those figures remain below the 8.6% consumer inflation figure, meaning that real wage income continues to suffer from the higher levels of inflation, the risk being that worker demand for higher wages goes on to exacerbate inflationary pressure in the US.
Growth expectations continue to fall
In line with the ongoing deceleration in macroeconomic data more recently evident in the US, brokers are also becoming more pessimistic about economic growth over the quarters to come. As illustrated below, median estimates for real GDP growth (QoQ) for the next six quarters have been revised lower, a move particularly marked since Russia invaded Ukraine at the end of February (and which impacted Q2 and Q3 2022 estimates in particular). This negative trend gained traction in May, as most of the estimates edged lower against the backdrop of more persistent inflation pressure and the rising risk of recession in the US.
Our economists have reduced their GDP growth forecast to 2.9% in 2022 and 0.8% in 2023.
The US economy is showing signs of slowing, while more aggressive Fed tightening exacerbates recession risk
Following a disappointing US Q1 2022 annualized growth rate (-1.5% QoQ - mainly due to strong net imports and inventory destocking), the US economy so far continues to show signs of slow-down, as shown on the graph below. Indeed, even though the most recent ISM manufacturing PMI reading for May came in above expectations (56.1 vs 54.5) and was up from prior’s 55.4, the trend in this leading indicator has been negative since the beginning of 2022. Meanwhile, the University of Michigan consumer sentiment index dropped to an all-time low last week, much lower than expected, in a clear sign that inflationary pressure and higher interest rates on mortgages have been weighing on US consumer. Such disappointing figures may imply further deterioration in US economic activity in the months to come.
While the Fed is clearly focused on doing what it can to tame inflation, recession concerns over months to come will also build as it continues to pursue policy tightening. There is also argument that the upcoming mid-term elections might also have an implicit impact on how the Fed moves in the near term.
A synchronized hawkishness across global central banks risks accelerating the deterioration in economic momentum
Due to its leading economic position, the US market is very sensitive to global financial conditions. For the first time since the post-GFC recovery, close to 60% of the 40 central banks around the world that we are tracking have started to tighten financial conditions (which is a record over the past 20 years).
We have built a crude “PTS Central Bank behaviour model” that aggregates central bank decisions, whereby a hike accounts for +1 and a cut -1.
As illustrated below, the model neatly follows the trend in the US ISM manufacturing gauge (with a 12-month lead). It also appears particularly accurate in finding inflection points in the ISM, tops and bottoms in the central bank model matching peaks and troughs in the ISM. The velocity at which changing financial conditions will affect the real economy can vary over the time, but the model points to a significant deterioration in economic momentum over the coming months:
The Fed has an unenviable task
Since Friday’s hotter-than-expected CPI print, markets have decided (and priced) that the FOMC will have to be more aggressive as it seeks to battle inflation if it is to catch-up and combat the pace of rising prices, while recent leaks (voluntary?) in the financial press regarding a potential 75-bps rate hike at today’s meeting may have paved the way for a more hawkish stance from the Fed in the few months to come.
While the pace at which the Fed decides to tighten remains uncertain as we write, the risk that it accelerates in the short-term (and gauges the effects of higher rates on the economic activity and inflation later in 2022) has risen. On a medium-term basis however, with economic growth already showing some signs of weakening, the Fed might still decide to slow down its tightening pace and adjust its policy (either by pausing or ceasing the tightening cycle or reducing the magnitude of rate hikes) in efforts to avoid a so-called hard landing.
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