U.S. Inflation = Fed keeps on keepin' on

Patrick O’Toole, Adam Ditkofsky and Pablo Martinez - 10/14/2022

Economic Data

The mantra last year that inflation was ‘transitory’, has given way to inflation will remain sticky. Thursday’s U.S. CPI report was disappointing in that it was higher than expected, with the core rate (which excludes food and energy) posting a fresh 40-year high. The futures market immediately moved to solidifying expectations for a fourth consecutive 0.75% hike in the Fed Funds rate at the November 2 meeting, and also moved up the odds for a similar increase on December 14. It also raised the terminal rate (expected peak in Fed Funds) to roughly 4.75%-5.00% by March. The Fed’s FOMC minutes from Wednesday did little to indicate that the Central Bank is poised to pivot any time soon, and the inflation report will embolden them to keep going, even though future expectations for inflation are relatively muted.?The 2-year breakeven inflation rate is at about 2.6%, and consensus forecasts see inflation below 3% by later next year.

The market reminded us that higher yields can have unexpected consequences. The U.K. pension industry has shown its vulnerability to the effects of strategies undertaken in a low interest rate world.?When rates spiked, issues surfaced with the hedging/leveraging strategies they used to boost yields in Liability-Driven Investing (LDI). The increase in yields led to collateral calls, and it didn’t go unnoticed on this side of the pond. This isn’t the first casualty of the higher interest rate environment, and will unlikely be the last as every time the Fed embarks on a tightening cycle, we see something fail and cracks appear in financial assets.?We’ve already seen crypto get whacked, Credit Suisse credit default swap exploding, and now we get the U.K. pension plan LDI debacle.?Each cycle we learn about something new that was an obscure part of the financial system; this time we’re all getting an LDI 101 course.?Is this the start of a wave that will soon hit North American shores??Well it certainly seems to have impacted bond and stock markets already.?U.S. bond market liquidity is drying up, and the stock market has taken notice.?Will other skeletons soon emerge from unknown closets? It seems increasingly likely.

On the brighter side, the U.S. consumer is holding up okay. Yes, the housing market is struggling, but even though incomes aren’t keeping up with inflation, overall compensation is fairly strong, owing to good job growth and hours worked. Today’s U.S. retail sales report showed a flat reading in September. Although the overall number was lower than expected, revisions for the previous month were higher. The number was dragged down by auto sales which are struggling due to supply chain problems. The control group, which measures sales volume and is an important part of GDP calculation was higher than expected, which is positive for the economy.

Bond Market Reaction

It was quite something to watch the bond market’s response to higher than expected U.S. inflation yesterday.?A swoon in prices was the knee-jerk response as it looks like the Fed will march on with 0.75% increments.?Canadian bond prices though recovered by mid-day, likely due to lower inflationary pressures and indications from futures markets that the Bank’s terminal rate will likely be lower than that of the U.S. On the week, yields were little changed, however, with Canada’s 10-year benchmark still not exceeding its June high, while the U.S. 10-year yield peaked at a fresh high of 4.08% before settling back below 4%.

The corporate bond market showed its vulnerability to rising recession risks as credit spreads in investment grade and high yield climbed on the week.?The high yield sector is back to living up to its label, with the U.S. benchmark yield poking above 9%, a level not seen since 2016 (outside of the panic days during the onset of the pandemic).

Stock Market Reaction

Since when is bad news considered good news? US equity markets saw one of the most violent intraday reversals after this week’s CPI print which was above market expectations. Although there was no credible explanation for the move, investors in general have been quite nervous about rapidly rising rates and what it means for the economy. With Q3 earnings season starting up next week, commentary from companies will be informative in gauging consumer sentiment and underlying demand trends. In the meantime, a few noteworthy developments. Taiwan Semiconductor, the largest global foundry, cut capex/growth plans by $6bn citing market uncertainty over the short-term. Capex plans at Taiwan Semi and other competitors are often watched closely as an indication of end-customer demand, and many equipment suppliers sold-off in expectation for weaker sales in coming quarters. On an unrelated note, streaming wars and increased competition have led to Netflix launching an ad-supported plan for $7/month, targeting more budget-conscious customers. Subscriber growth has been weak at Netflix for the past few quarters due to higher cancellations and a weaker content pipeline. It remains to be seen whether this new model will lure customers into signing up again – it certainly seems like a viable option for certain emerging markets.

What to Watch Next Week

We’ll see our CPI report next week, along with housing data, the Bank of Canada’s business outlook survey, and retail sales.?The U.S. releases industrial production and housing data.

Disclaimer

Patrick O’Toole is Senior Portfolio Manager, Global Fixed Income; Adam Ditkofsky is Senior Portfolio Manager, Global Fixed Income; and Pablo Martinez is Portfolio Manager, Global Fixed Income.

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