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Markets are convinced that inflation has already peaked and that interest rates should follow suit by Q2 this year.
The Fed remains more skeptical and awaits evidence of services inflation turning a corner.
Chart 1 shows the returns accrued by the FT Wilshire 5000, US bonds and the US dollar from the low point reached on October 14th last year and performance YTD for 2023. While both equities and bonds have rallied strongly the dollar has fallen sharply. The common denominator between these divergent moves is growing conviction that US inflation has already peaked and that US interest rates will follow suit.
Chart 1: Move in US assets since October 14th low and YTD
Source: Wilshire, Refinitiv, FactSet. Data as of January 17, 2023
Chart 2 plots the key US inflation indicators and shows a profile of inflation peaking (and subsequently declining) over the last six months. In fact the Fed's key indicator the Core PCE deflator peaked in February 2022. It also appears that the Fed ramped up its hawkishness as evidence of the peak started to appear.
Chart 2: Key US inflation gauges appear to have peaked several months ago
Source: Wilshire, Refinitiv and Federal Reserve. Data as of January 17, 2023
Chart 3 shows that the key driver behind the peak in inflation has been the rapidity of the decline in both goods inflation and input prices as measured by the PPI indicator. Services inflation has yet to peak, and the Fed will probably need to see this confirmed in subsequent data to change tack on interest rates.
Chart 3: Declining goods inflation but services inflation (the Fed's focus) remains elevated.
Source: Wilshire, Refinitiv and Federal Reserve. Data as of January 17, 2023
Chart 4 plots both the markets interest rate and Federal reserve dot plot curve forecasts. The market expects rates to peak close to 5% in Q2 but then to 'fade' lower into the second half of the year as growth headwinds and disinflationary pressures push rates lower. However, Fed forecasts paint a picture of continued increases throughout the course of the year reaching peak rate by the end of the year (higher for longer).
Chart 4: Mind the gap between the market and Fed interest rate forecasts
Source: Wilshire, Refinitiv and Federal Reserve. Data as of January 17, 2023
While the Fed is still waiting for more evidence of inflation peaking it has been concerned that the deliver of restrictive financial conditions runs the risk of slowing the economy too aggressively and has subsequently started to rein in (taper) the scale of interest rate increases it is delivering at the FOMC meetings (see Chart 5). Tapering has been a contributory factor behind the weakening of the dollar.
Chart 5: The Fed is tapering the magnitude of rate hikes - impacting the dollar
Source: Wilshire, Refinitiv and Federal Reserve. Data as of January 17, 2023
Read more in our latest Market Driver Insights report.
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The likelihood of the delivery of sustained disinflation in 2023
Despite persistent fears that financial conditions are sufficiently restrictive to cause a slowdown next year, the positive market reaction to the weaker than expected October CPI data seemed to indicate a transition to a new phase of inflation dynamic analysis - the likelihood of the delivery of sustained disinflation in 2023.
Bad economic news feeds this narrative and therefore could now be seen as good news.
Chart 1: On the cusp of phase 3 of inflation analysis
Source: Wilshire, Refinitiv. Data as of November 15, 2022
Intensified focus on the Fed’s disinflation forecast for 2023
Chart 1 plots the progression of the Fed’s core PCE inflation indicator. The twelve month period between February 2021 and February 2022 saw the inflation rate almost triple, generating the hawkish tilt by the Fed. Since then, the inflation rate has plateaued (albeit at an elevated level).
The focus now turns to the plausibility of inflation moving sequentially lower next year as predicted by the Fed. Their current forecast of year-end 2023 inflation reaching 3.1% requires a monthly run rate of 0.3%. A run rate of 0.2% a month would deliver a 2.4%-year end inflation level.
Forward looking indicators such as the ISM prices paid index point to continued downward pressure on headline inflation in the coming months.
Chart2: The ISM manufacturing prices paid index points to lower US CPI
Source: Wilshire, Refinitiv. Data as of November 15, 2022
Perception that inflation could be peaking and then encountering disinflationary headwinds (after the October CPI report) produced a downward shift in the US interest rate curve as can be seen in Chart 3.
Any further signs of weakness in final demand (bad news) could now be the catalyst for continued downward shifts in the interest rate curve (good news).
Chart 3: US market rate expectations fell after the lower-than-expected US CPI numbers
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Movements in US 30s/10s curve generally lead 10s/2s despite focus on 10s/2s
The 2021/22 flattening of the US Treasury 10s/2s yield curve, which has been close to full inversion in Q2, has prompted discussion of whether the curve is signaling a recession. In contrast, there is little focus on the 30s/10s yield curve, even though it has generally led movements in the 10s/2s curve, as Chart 1 shows.
Chart 1: The 30s/10s yield curve has generally led movements in 10s/2s curve
Source: FactSet
Chart 1 also shows some similarity between recent bear flattening* yields rising more in 2 yrs than 10 yrs - and the 10s/2s flattening in 2018. The 30s/10s yield curve has also been flatter than 10s/2s for most of the last 12 months, as it was during the bear flattening in 2017/18.
But yield curve dynamics and the Fed's policy cycle also show distinct differences in 2022, from 2018/19. Then, markets moved quickly to price in lower 10 year and 2 year yields once growth began to slow, effectively front-running Fed policy easing, with no inflation problem to consider. The 10s/2s yield curve then bull flattened**, in the late-cycle move, pre-COVID. In 2022 however, the 10s/2s yield curve has steepened since early April, the Fed has only just begun tightening and is dealing with a major inflation shock, and there is no clarity on where the terminal rate for Fed tightening will prove to be. The Fed's dot plot projections have already been revised steadily higher, in line with the higher inflation forecasts.
Chart 2 compares the bear flattenings of the US 10s/2s curve in 2021/22 and 2016/18 and shows greater curve flattening in 2021/22, as 2yr yields have risen about 80bp more, even if 10 yr yields have also risen more than in 2016/18. The bigger yield moves have also occurred within the same 24 month timeframe in 2020/22, as 2016/18, so the move has been relatively faster.
Chart 2: 2021/22 bear flattening exceeds 2016/18, but when will a bear become a bull?
Source: FactSet
This has helped drive a faster tightening in financial conditions but bull flattening of the yield curve has not yet occurred. Although Treasury yields, and inflation breakevens, have fallen in the May rally, this has caused the 10s/2s curve to steepen - see Chart 1 - whereas bull flattening proved the key signal for weaker economic growth in 2018/19.
*A bear flattening of the yield curve occurs when short dated yields (eg, 2 yrs) rise more than longer dated (e.g. 10 yrs).
**A bull flattening of the yield curve occurs when short dated yields fall less than longer dated yields.
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Stung by the persistency and level of inflation and the accusation of being behind the curve the Federal reserve has cranked up its hawkishness
This is reflected in a significant shift in market interest rate expectations since the Russian invasion of Ukraine in late February.
Chart 1: A significant shift in US interest rate expectations since late February
Source: Refinitiv
The next few FOMC meetings are expected to deliver 50bps increases in the Fed funds and see the contraction of both Treasury and MBS holdings.
What is unusual is that the Fed are tightening at a time when both Consumer Confidence and Real Incomes have fallen to levels last seen at the lows of the GFC recession. Normally the Fed would be considering accommodation with indicators at these levels.
Chart2: The Fed are tightening into extremely weak Consumer Confidence and Real Income levels
Source: Refinitiv
Another clear risk is that the Fed have turned more hawkish just as aggregate financial conditions ( a measure of the combined impact of shifts in monetary policy, the credit cycle and foreign exchange) have tightened very rapidly( much faster than during the previous cycle) and are on the cusp of turning restrictive.
Chart 3: US FCI's have risen very rapidly and are on the cusp of turning restrictive.
Source: Refinitiv
When rates are seen as above the neutral rate each incremental move is seen as creating significant headwinds for subsequent growth. Gauging neutral rates by measuring the ratio between consensus nominal GDP growth rates and terminal interest rate forecasts the US is now at neutral rate levels.
Any more tightening from here could start to be perceived a policy mistake.
Chart 4: US rates are already approaching 'neutral' levels
Source: Refinitiv
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