Second Wave or Bump in the Road?
Checking in on US inflation
For many market participants, this week’s US inflation data is regarded as a crucial gateway to interest rate cuts later this year. It is widely expected to come in soft, allowing the Fed to reduce interest rates over the summer months, as per its previously communicated guidance
Curiously, at the same time, financial markets over the past weeks have been increasingly shaped by a “monetary debasement bid”, where real assets are aggressively bid in a presumably valuation indifferent way
As an example, the price of gold (a low volatility asset) appreciated ~5% in April alone, even as interest rates rose across the curve. In other words, investors preferred to own gold, which pays nothing, over cash US Dollars, even though the reward on the latter improved. A highly unusual dynamic last seen at scale during the 1970s. This only makes sense if one expects the purchasing power of said US dollars to decline significantly
So which one is right? The many forecasters who see inflation as about to be retired to recent financial history given likely near-term softness. Or financial markets with their monetary debasement bid?
Now, I have no way of predicting this week’s CPI and PPI prints which, like most government data, contain a large element of randomness (though I do note that March inflation swaps have trended up recently, likely due to higher gasoline prices). But I would agree that the market has reasons to be concerned about resurging inflation risks. Here is why:
Large part of the sharp inflation decline of the past 6 months was owed to the goods economy, with services still sticky at an uncomfortably high level. Destocking and a depressed China did much of the work here. In fact, with long leads, goods pricing is likely to continue to be weak for a few more months
Yes, this is today, but the market is forward looking. And what does it see? It sees global manufacturing now expanding for the first time since 2022, e.g. as measured by the ISM Manufacturing survey
While surveys always come with all sorts of drawbacks, given the ISM matches with other important variables such as the swing in US-retailer inventories as well as expanding electricity consumption in China, I take it as a good proxy for the global goods economy
Unsurprisingly, commodities have started to move, too. But there is more to it. While the improving goods economy cycle gives investors reason to buy them, the real motivation comes from elsewhere
What is that? Simple - Jerome Powell gave a very dovish press conference a few weeks ago that point-blank dismissed any inflation risks. While he may be lucky and right, as I wrote at the time, in my view it wasn’t good Central Bank policy. The risk of resurgence definitely exists, dismissing it is not credible and in fact increases exactly said risk
Why? Because credibility is the highest good for a Central Bank. If it is weak, investors worry about the value of their money, and seek protection. It is no surprise that the “monetary debasement bid” started the moment Powell ended the press conference
Many market participants had a different view on inflation risks, whether right or wrong. But by ignoring the risks entirely, Powell gave them the reason to pull the trigger on protecting against them
So what did they buy this time around? Gold and commodities. This is how inflation in face of a dovish Central Bank can become a self-fulfilling prophecy. Rising commodity prices feed directly into higher inflation expectations, which investors protect against by buying exactly said assets - a circular reference of higher prices
We see this statement in financial markets data. Here is a chart of the 5-year US inflation expectations. It has steadily increased since the Fed’s pivot in November ‘23. Put this on top of your screen and follow it closely
Now, there are also many signs that the US economy is slowing (e.g. weak retail trends, slowing wage growth as per Indeed), but this post-Covid cycle remains unusual. In other words, the goods economy (1/6th of GDP) can recover while services (5/6th of GDP) slow down. Which means that inflation can - at the very least temporarily - pick up into weaker economic growth, just as inflation slowed in H2 ‘23 into torrid economic growth
My view is that commodities will remain bid until either this nascent global industrial recovery falters, or the Fed leans hawkish again. As long as they are bid, the market will likely continue its monetary debasement narrative, no matter what near-term CPI prints say, as the market likely looks through them
This bid also extends to house prices, and eventually rents. Redfin data shows house prices are up 6.6% y-o-y, the most since September ‘22. It seems unlikely to me that this doesn’t eventually translate into rents
What does that mean in the near term? Let’s say the CPI print comes in on the low side and short-term yields decline in expectation of the now more likely Fed cuts. In response to this easier money, commodities would be bid more, leading in turn to higher long-term yield and a steeper yield curve
Summary:
Near-term inflation may continue to slow, with possibly weak CPI/PPI prints ahead
However, financial markets are already looking past that. With the industrial complex in expansion for the first time since 2022, commodities have caught a bid, substantially aided by worries around monetary debasement
Absent a less-likely u-turn in global manufacturing, these self-fulfilling inflationary pressures likely continue until the Fed acknowledges them
The interesting part comes when/if the market realises that amidst fiscal dominance the Fed can in fact not do much, even if it wanted to, as higher rates likely add more private sector income than they slow the economy, with only the Treasury able to make a true difference. But this realisation, which would sharply accelerate the bid into real assets, is perhaps still some time away
What does this mean for markets?
The following section is for professional investors only. It reflects my own views in a strictly personal capacity and is shared with other likeminded investors for the exchange of views and informational purposes only. Please see the disclaimer at the bottom for more details and always note, I may be entirely wrong and/or may change my mind at any time. This is not investment advice, please do your own due diligence
In my last post, I highlighted gold, gold miners, the commodity index, Tesla and the Swiss Franc:
While gold, the commodity index and especially gold miners caught a strong bid, the Swiss Franc has leaked lower (I am stopped out) and Tesla has chopped sideways as excitement over FSD 12.3 is kept in check by very poor near term sales. I don’t know which one will win near-term
Staying with the theme of slower EV sales, in addition to an improving industrial cycle as well as investor preference for monetary debasement hedges, I see Platinum and Palladium as attractive (see Le Shrub’s great write up on the topic here). A likely higher near-term hybrid penetration means more automotive demand for these metals relative to recent expectations, while demand for other industrial use cases improves and Platinum as the world’s rarest precious metal benefits from the gold-like monetary hedge. It has massively lagged vs gold, as per the platinum-gold ratio chart below from Shrub’s post. Rather than buying the metal itself, I’ve bought a small position in PGM producer Sibanye Stillwater. It is down 80% from highs, highly levered and provides an asymetric risk-return profile to higher PGM prices. (Please always do your own due diligence and use stops!)
On a more general note, inflation caused by money printing (e.g. within a high deficit) is usually good for equities as the value of real assets rises vs paper money
This is different if there is a Central Bank fighting it, or if inflation is due to supply shocks (oil embargo etc). Money printing of course invites supply shocks caused by bad geopolitical actors. So as long as the Fed stays dovish and there is no big escalation in the Middle East, from the inflation side there is not much worries for stocks
However, there is also liquidity. As mentioned in recent posts, I see the latter as headwind over Q2, as a net-negative bill issuance drains liquidity for the private sector, thus I am keeping exposure light until that changes
For that, I have a keen eye on the 1st May QRA, which could still show low bill issuance as I suspect that the tax intake comes in better than expected. However, from the summer I’d assume a return of the liquidity firehose and another big ramp in asset prices
Should bonds rally on weak CPI/PPI data, I would fade that move, especially as long as the commodity complex remains bid
Finally, as the market is a never ending sequence of narratives, a new one surely isn’t too far away. Perhaps next ahead is again the story of an economic slowdown due to higher long-end yields and higher input prices, and then higher bill issuance as well as Fed cuts to help growth pick up again (to be clear, not imminent, but perhaps next…)
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Great as always Florian. Cheers!
"investors preferred to own gold, which pays nothing, over cash US Dollars"
Could that say something about the buyers in addition to their inflation expectations? I'm sure you've seen the Twitter accounts suggesting gold's strength comes from foreign central banks buying the barbaric relic after the US confiscated Vlad's Treasuries. Inflation would not be their primary reason for buying gold.