Authored by Simon White, Bloomberg macro strategist,
Bonds and especially equities are vulnerable to an unanticipated reversal in the disinflationary path.
The trend isn’t always your friend. Today’s CPI release is expected to show a continuation in the easing direction of both core and headline inflation. But global cyclical pressures are poised to rise again, threatening to derail the steady fall in headline inflation to 2.5% by June expected by CPI fixing swaps. Financial assets are open to significant downside risk.
Last week, the focus was squarely on the new prospective BOJ Governor, but money and credit data released out of China highlighting rising inflation risks will be far more consequential for markets in the shorter term.
To see this, we need to look under the hood of US inflation. Its fall in recent months can be dissected in several ways. Services versus goods inflation is one, with services inflation expected to remain stickier as wage growth feeds through.
However, more illuminating is to divide inflation up into cyclical and acyclical components. This is a cleaner way of separating inflation into the parts where the Fed’s interest-rate policy can have an impact versus where the Fed has less control.
The San Francisco Fed produces a cyclical inflation index by aggregating the components of the core PCE index that correlate well with the unemployment gap (i.e. the difference between the current unemployment rate and its natural level). The acyclical inflation index is anything not considered cyclical.
The decline in core inflation has thus far been driven by a fall in acyclical inflation. Cyclical inflation, on the other hand, has remained stubbornly high and has yet to fall.
This tells us that global disinflationary forces have been the primary driver of lower US inflation, while Fed policy has yet to have an impact. In fact, in a tightening cycle it takes an average of six months after the Fed’s last hike for cyclical inflation to peak and start falling.
Thus it may be several months yet before tighter policy begins to have a cooling effect on prices.
That means acyclical – i.e. globally-driven – inflation needs to continue to ease to keep overall inflation trending lower.
But here lies the rub, as acyclical inflation, it turns out, is just China. The chart below shows a very close relationship between acyclical inflation and PPI in China.
The data from China last week showed that after several false starts, the economy looks to have finally turned a corner after Covid. Key was a surge in credit and the above-expected rise in M1 money growth.
Real M1 growth is the best cyclical leading indicator for China. It has correctly signaled almost all the ups and downs in China’s economy over the last decade and a half. Its rise shows that easing in China is now gaining traction, which means China’s recovery is on the cusp of inflecting higher.
PPI is thus prone to rising again soon, taking acyclical inflation in the US higher too. But this will come before Fed policy has fully kicked in – meaning inflation is likely to begin rising sooner than the market expects, or the Fed would like.
CPI fixing swaps are not pricing this, therefore it’s unlikely to be accurately reflected in other markets either. Both stocks and bonds are vulnerable, especially after both had such a strong start to the year, but bonds have already given back most of their gains as the market begins to price “higher for longer”.
Stocks, though, look particularly exposed to upside inflation surprises. They remain near their highs for the year, and they have been heavily front-running the disinflation trend, with the rally being led by sectors with high duration such as tech and consumer discretionary.
After one of the best starts for decades in 2023, the stock-bond ratio is vulnerable to a much deeper correction. As the chart below shows, the ratio is only back to “fair” value, and has not yet overshot to the downside as it does after such a large upside overshoot – and often at the end of the economic cycle.
Stock hedges continue to be a sound policy, while in rates the smarter play is not chasing bonds lower, but looking at the next move but one: tighter policy now means looser policy later, and deeper cuts are likely to be priced in in late 2023 and 2024.
That part of the Eurodollar curve (e.g. the Dec 23 vs Dec 24 spread) should therefore continue to flatten.
An even bigger risk is that an arrest in inflation’s fall emboldens the Fed to hike more than currently envisaged. But that would entail a much deeper recession and weaker asset prices than it wants, or currently has a mandate for.