Is Inflation Going To Ease?
Osman Turkmenoglu
Quantitative Analyst | Trading Strategy | CFA Level II Candidate
Since I managed to accurately foresee the earlier rate hikes, the next question is how soon the inflation is going to ease, because that’s going to play a crucial part in the later stages of the monetary policy and once again my goal is to position strategically in months advance.
So, I will be breaking down each category according to their importance and their contribution to inflation to see what is the specific reason and how soon it can be solved.
Food
Starting with the food which has %13.990 importance in the overall CPI. Food prices in general inflated as much as 6.5% YoY which is significant. As a sub-category, meat, poultry, fish and eggs prices rose 12.5% YoY which is the highest in the food category.
Since the meat category contributed the most to the overall inflation, I dug a bit deeper and apparently, The White House did as well. According to the white house, the majority of price increases are due to four large companies who control the 55-85% of pork, beef, and poultry market are taking advantage of increasing prices to maximize their profits.?
Data says the same thing, the middleman is underpaying the farmers and taking their profits to record levels. According to the companies’ latest quarterly earnings, their gross profits have collectively increased more than 120% since the pandemic and their net income skyrocketed more than 500%. They have also announced a billion dollars in dividends and stock buybacks on top of the 3 billion they have already paid out to investors since the pandemic began.
It would be very inaccurate to think that’s cost-push inflation since meat processors increased their gross margins by as much as 50% and net margins by 300%. If the costs were to rise, those margins would’ve remained flat and there wouldn’t be a dramatic increase.
Also, according to the white house, Tyson Foods increased its prices more than the cost of goods sold and increased the price of beef by more than 35% which made them record profits while selling less beef than before.
To conclude, besides rising costs and supply chain issues, the majority of the price increases are to take advantage of increasing costs to increase profits further. However, the Biden Administration already announced that they are taking strong actions to crack down on illegal price-fixing and enforce the antitrust laws. They are investing hundreds of millions of dollars in meat processing and encouraging competition to break the price-fixing, basically using the best tool of capitalism.
Energy
Energy is the most inflated category in the whole CPI data. It has an importance of 7.54% which I find interesting. The energy category inflated 29.3% YoY and the majority of the inflation comes from energy commodities. Fuel oil increased 41%, motor fuel increased 49.5% and gasoline increased 49.6% YoY.?
The inflation on energy commodities is significant and ongoing political tensions between Ukraine and Russia combined with OPEC not being able to fulfill its output increase promise is not helping. Lastly, utility gas service is also important to consider which inflated more than 24% YoY.
This significant price increase is mostly due to the fact that OPEC decreased its supply from 32.16 million barrels a day to 24.24 million barrels a day due to a significant drop in demand during lockdowns and oil prices crashed to historical lows. Barrel price of crude oil saw 0.01$ on spot markets. OPEC wanted to balance the supply and demand, so they curbed a significant amount of production last year which fueled the rally from 0.01$ to 88$ a barrel this year.
Since economies opened really fast, stimulus programs also helped to fuel the economy above pre-pandemic levels which also caused the overheating of many economies. Additionally, OPEC has been very slow to increase its output to pre-pandemic levels and is still not being able to?meet its promise of increasing 400,000 barrels per day.
However, the production is still increasing and with the upcoming monetary tightening, global economic growth is expected to slow down.?
According to IMF’s January 2022 World Economic Outlook, global growth is expected to slow down from 5.9% in 2021 to 4.4% in 2022. The slowdown largely mirrors the slowdown in the largest two economies, U.S and China both expected to have slower growth in 2022.?
This slowdown is expected largely due to upcoming monetary tightening for the U.S. and additional financial stress on property developers in China. The property development slowdown already puts a lot of pressure on commodities and increasing rate hikes in global markets are not going to help either.?
Also, there is still the risk of new and stronger variants which might cause more lockdowns in China because of their zero-tolerance Covid-19 policy.?
In the meantime, the United States is ramping up the number of oil rigs quite fast. It is still below pre-pandemic levels but the number of crude oil rigs keeps increasing since oil producers are making attractive profits and high oil prices are hurting the economy, the U.S is motivated to increase its production.
U.S weekly production is up near historical highs and according to the Energy Information Administration, it is expected to grow beyond that level and will reach new highs.
EIA expects U.S production to increase 6% in 2022 and 5% in 2023 since the crude oil prices is expected to remain elevated enough to encourage production and the improvement in drilling efficiency is expected to increase as well.?
Natural Gas is also an important part of the elevated CPI since it’s inflated more than 24% YoY and mostly due to political tensions between Russia and Europe. Europe has been implementing a transition to clean energy for the last 20 years and represents 33% of the EU’s total electricity consumption. However, there is not enough power coming from renewable resources and even when it’s present, it is usually not a reliable source of energy.
Additionally, after the Fukushima disaster, Merkel pledged to shut down nuclear plants in Germany which caused a transition from an electricity exporter to an importer. This made the country more dependent on Russian natural gas and more sensitive to political relations.?
Russia took the opportunity and used the power, cutting the natural gas flow to Europe which caused the natural gas crisis. Natural Gas prices increased more than 300% since the pandemic began and still remain elevated due to ongoing political tensions between Ukraine and Russia since Europe can’t get involved with the fight since they are pretty tied up already.?
However, natural gas consumption is very cyclical since it is mostly used to generate heat. Since we just entered February, there is not much time left till people will need less heating across Europe and around the world as well.?This is likely to ease down the natural gas prices in 2 months as we move closer to Spring.
Now the United States comes in help and brings Qatar as the alternative as Europe’s more reliable gas supplier. Qatar has a good track of record being good friends with the West and looks like it will be the short-term solution to Europe’s natural gas crisis.
However, the majority of Qatar’s production is tied up in long-term contracts which leaves very small spare capacity to supply Europe in the short term since they don’t have much space for spot market. Nevertheless, I think U.S and Qatar will reach a deal that will help relieve Europe from its short-term natural gas crisis. That would not solve all the problems but would ease the rising prices.
Additionally, for the U.S first rate hike is expected to happen in March and it will bring down the demand for many commodities since the demand for many products will fall as well. All the stimulus checks and low-interest rates encouraged consumers to spend more in the short term which caused supply chain bottlenecks that pushed prices even higher.
However, this is not likely to last as borrowing gets more expensive consumers are going to have less demand which will bring down the prices of commodities including energy. Also, as growth slows down, global demand will slow down for energy commodities as well since the amount of investments and production is not going to be the same as in the low-interest-rate environment, which will also push down the prices.
Similar to 2008, there are many small supply disruptions such as events happening in Libya and OPEC not being able to meet its output increase promise. Similar events happened in 2008 as well, Venezuela nationalizing its oil production and had conflicts with ExxonMobil, and conflicts in the Middle East once again disrupted the overall supply. Prices increased to their all-time highs since analysts expected a significant shortage which seemed possible for a short period of time. However, demand slowed down significantly due to a recession and contraction in credits, markets turned into an oversupply which caused a crash from 147$ a barrel to 33$ a barrel in months which totaled a -77% decline in the price of oil.?
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The same thing happened in 2014 as well, due to ongoing political tensions and conflicts, oil prices remained elevated for a while and as soon as markets switched to an oversupply in 2014, oil got hit once again and lost -75% of its value in 2 years made the price of oil very cheap.
There is an obvious pattern in oil markets, prices are tended to go significantly high if there is a chance of a supply shortage and as soon as the market turns oversupply, prices come crashing down along with slowing global growth. It is clear that the market overreacts to both possible supply shortage and oversupply. The situation is pretty similar and according to EIA same thing is going to happen. As United States crude oil production continues to near all-time highs, oil markets are expected to become oversupplied as soon as Q2 2022.
It is also important to understand there is a balance of supply and demand in oil markets, as prices go beyond equilibrium, demand basically drops down and oil markets push itself towards the edge of a cliff that causes a major price decrease in a very short amount of time.
Considering the fact that, supply increase in both OPEC and non-OPEC countries along with the upcoming rate hikes, it is expected to see a slowdown in global growth which will once again crash the price of oil significantly, relieving the stress on CPI after Q2.?
All Items Less Food and Energy
This is the last category of the CPI, there are many subcategories under this but I will focus on the ones that had the most increase in prices and had the biggest impact on the CPI.
Starting with commodities less food and energy, that subcategory represents 20.77% importance and inflated as much as 10.7% YoY. Since there are many commodities, it would be nearly impossible to take a look at each and every one of them, however, it can be said that commodities, in general, are always used to hedge inflation risks which also boosts prices further.?
Nevertheless, prices do see significant drops in a short amount of time when the monetary policy starts to tighten. As fixed income securities start to offer more favorable returns via rate hikes, investors exit their risky hedge positions to take safer fixed income positions which creates a chain reaction and a sell-off across the board.?
As seen on the chart above, the commodity ETF has risen significantly alongside increasing risks and inflation and corrects sharply and declines significantly as soon as rate hikes come into play since investors quickly exit their positions to avoid any losses and put their money into fixed-income securities.
Once again, commodity prices have risen over 150% since the pandemic and will eventually decline as soon as rate hikes begin. This will bring down the excess commodity inflation to normal levels which make that category less of a worry.
On the other hand, there is a more serious worry. Used cars and trucks prices have risen over 37% YoY and new cars have risen over 10% YoY. This is not something that economists see very often and is a very specific case so far.
When the pandemic began, car manufacturers decreased their production significantly since there were both lockdowns and travel restrictions which crashed the demand for cars. However, during that time chip manufacturers got more and more orders from electronic manufacturers since both students and employees started to work from home which increased the demand for laptops.?
As a result, during the absence of car manufacturers orders’, leftover capacity was quickly filled which left little to no place for car manufacturers when they started to operate again.?
Car manufacturers were left with less availability for orders which caused delays in-car delivery dates. That pushed consumers into the used cars market to get quick deals and enjoy the low-interest funding with affordable payment options.?
Additionally, during lockdowns many people were able to save a lot of money since there was nothing to do and nowhere to go, with the addition of stimulus checks, the demand returned much stronger. Also, considering the fact that auto sales usually peak at the year-end made the bottleneck even worse.?
This gave used car dealers a significant advantage since there were a lot of buyers and not many sellers. As the balance of demand and supply got ruined, car dealers jacked up their prices because they knew if one customer passes the offer, the other one would take it.
Manufacturing companies became so desperate that they removed certain features from their cars to keep the production going, such as?Tesla dropping power lower-back support in the passenger seat of certain models.?
Additionally, last year when the pandemic hit, car rental companies sold their inventory due to travel restrictions and low demand. That also made it worse for the consumers since car rental prices went up by 43% YoY, giving the consumer very little space to move and making car dealers very advantageous.
However, the supply of chips has improved but still remaining as a problem. The demand and prices are expected to correct as interest rates rise since buying cars are not going to be cheap in monthly payments and many already choose to keep their existing cars and fix them up instead of looking for a new one.?
How Fast The Inflation Will Go Down?
It is very important to consider the fact that soon there is going to be an inverted yield curve which means investors are investing in the long-term contracts rather than short term ones since the short-term outlook on the economy is not clear and they want to take the opportunity of having high-interest rate payments for a long time.?
As investors take advantage of long-term bonds, the price of the bonds increases, and yields remain relatively stable. Nevertheless, short-term bond prices go down and yields start to go up much faster. This creates an inverted yield, where short-term treasuries pay more than long-term bonds, which means costlier short-term borrowing which has a direct effect on businesses and consumers.
Since we live in a world where everyone buys their needs using debt, it is going to have a significant impact. The non-housing debt balance keeps growing, consumers are taking advantage of low-interest rates for both housing and non-housing debt to get what they want as soon as possible.
However, inflation is catching up. Median household income is still down trending and CPI had a sharp increase which makes it harder for consumers to buy their needs. FED is in a tight place, and they know it. The NFP report came in surprisingly good which is expected to make FED more hawkish and as soon as FED becomes more decisive and scarier about being hawkish, the demand will slow down.?
That will start to slowly decline the inflation and as global growth stalls, commodity investors and businesses that are stocking up on high prices will start to sell their inventories. The market will create a chain reaction which will cause a sharp correction.
If the FED remains relatively indecisive and passive, it will take some time to bring down the inflation and I think it will do more damage to the economy in the long term. My take is that central banks around the world would become more hawkish to surpass inflation. There are many manipulative and hedging positions that are open to distribute the risk of inflation or stock up commodities, but it will turn into a sell-off as soon as rates increase, and investors favor the fixed income securities.?
I believe that this cycle has been really fast due to rapid changes in covid policies, and we have seen the economy recover and overheat really fast, and I think the same will go for the inflation. The sell-off in commodities will bring down inflation and a slowdown in global growth is going to fuel the selloff in commodities, most importantly oil. Oil will see sharp declines in the coming years, and I know this is an unpopular opinion, but I know the fact that supply worries can push oil prices to unsustainable levels which swiftly breaks down and lifts a huge weight from the economy.?
Additionally, the market is very fragile right now since valuations are already through the roof right now and take every bad news like a disaster. I expect the tightening cycle to continue through 2022 and 2023 but inflation is going to ease much faster than many expect.
From the perspective of currencies, I expect DXY to reach above near highs and I expect more pain for commodity currencies. U.S Dollar will be very attractive when the rates start to rise and investors will prefer American bonds and currency as the safe haven in a hawkish economy. Not only that, as stocks sell-off and people switch to cash, it also increases the demand for the currency. Additionally, the FED is expected to start the Quantitative Tightening in March along with the first-rate hike, which will also decrease the money supply in the economy and make the U.S Dollar more valuable.
For commodity currencies especially AUD and CAD, I expect hard times ahead as commodity prices crash, they will bring down the poorly diversified economies with them and weaken their currencies against the U.S Dollar. I expect approximately 15% more depreciation against the U.S dollar for these currencies and am already taking the advantage of long-term option contracts on currencies.
Thank you for reading.
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