Good News is Good News is Bad News

A lower-than-expected CPI report for July (8.5% vs 8.7% expected) had markets rallying in expectation of interest rates quickly coming back.
But stronger markets make the Fed’s job more difficult, potentially leading to more rate increases than expected. It is unlikely that would be received well by markets.
We don’t believe “happy days are here again”, and remain cautious in the near-term. We perceive more downside than upside from these levels.

In this volatility and confusion, we continue to look for attractive longer-term opportunities to diversify our portfolios and add attractive risk-adjusted return investments.

The Good News

According to the stock and bond market, good news is good news once again, as stock and bond prices rallied after the 8.5% July CPI print was lower than the expected 8.7%. One might think that 8.5% is hardly good news. On an absolute basis that would be correct, but the idea is that inflation might finally be heading down. If you recall, it was 9.1% in June.

The message from markets is that inflation is still high, but it is now moving in the right direction. The extension of that comment would be that in light of this change, the Fed would no longer need to raise interest rates as much as many had feared after the higher-than-expected inflation number in June.
If rates don’t need to be raised as high, that would imply that rates will be free to come back down sooner than previously thought. Thus, producing a stock and bond rally.

The table below gives some detail around the CPI data. Energy and food inflation are very volatile and can change direction very quickly and very violently. Energy prices were down a lot, which was obvious if you’ve purchased gas recently. Food was up a lot (again), which was also obvious if you’ve recently been in a grocery store or a restaurant.

Core inflation which excludes both food and energy, is much less volatile and therefore a bit ‘stickier’ and that is evident in the data. Core inflation is looking a bit persistent. We think it’s very important to watch the housing market for signals on the direction of core inflation. Interest rates are the primary tool used by the Fed to alter the pace of the economy, and housing is not only a significant part of the economy, it is also highly sensitive to interest rate changes. That is important because shelter is a large portion of the core inflation data.

But There’s a Catch

As we have all heard incessantly over the last several months, the Fed wants to slow the economy. They attempt to achieve that by making financial conditions tighter and the primary tool they use is increasing interest rates. But the Fed only controls very short-term interest rates and interest rates are only a part of ‘financial conditions’. For example, a rising stock market is equivalent to a loosening of financial conditions. Longer term bond prices rising (i.e., longer term interest rates declining) are again the equivalent of looser financial conditions.

What that means is that the recent market rally is working against what the Fed is trying to achieve. Hopefully, that will become a little bit clearer in the chart below. This is the National Financial Conditions Index (NFCI) created by the Chicago Fed. They describe the index this way:

Positive values of the NFCI have been historically associated with tighter-than-average financial conditions
Negative values have been historically associated with looser-than-average financial conditions.

We’re going to modify that just a touch and say that when the line is rising (the index is increasing) financial conditions are getting tighter at the margin. Conversely, when the line is declining, conditions are getting looser. With that in mind we make two observations:

Note the direction of the line. Over the past several weeks (as markets rallied) the line is declining indicating that financial conditions have reversed and are getting looser.
Note the absolute level of the line. It is below zero, which indicates that financial conditions are still somewhat accommodative relative to the long-term average.

There is nothing here that would imply the Fed will be tempted to lower interest rates anytime soon.

Are we there yet?

Like kids in the back of the car, markets want to know if we are there yet. Is it time to send out the ‘all clear’ signal to investors? We don’t think so. So many things can affect the direction of inflation… what if Russia and Ukraine strike a peace deal? What if China continues its Zero Covid policy? No one knows where inflation is going, but we are able to put some parameters around it.

The chart below shows the actual year-over-year inflation rate through July 2022, and then projects inflation based on steady monthly inflation rates of 0%; 0.2% (approx. 2.4% annually); 0.4% (approx. 4.8% annually); and 0.6% (approx. 7.2% annually). What quickly becomes clear is that If inflation is 0.4% in August, year-over-year inflation would actually tick up from July. Even if inflation from now through March of next year is 0.2% per month, which is very close to the Fed target, the year over year inflation rate will still be over 4% after the first quarter of 2023.

The lesson is that when inflation gets as high as it is, it takes some time to retreat and that implies that the Fed potentially needs to keep tapping the economic brakes for quite some time if it is to win this war. Over the last 25 years, the Fed has come to the rescue with increasing speed and urgency. Inflation hinders them from repeating that process and the response to economic malaise could come more slowly than the market has become conditioned to expect. Several Fed commentaries since the CPI data appear to confirm that message but markets continue to rally and the disconnect becomes that much greater. We suspect markets are jumping the gun.