Source: April 2025 Manufacturing Business Outlook Survey, Federal Reserve Bank Philadelphia

At the same time economic activity fell off a cliff, prices paid accelerated higher. A steady uptrend in prices paid was in place since last year, but in April they jumped to levels last seen in July, 2022. After spiking in January, the prices received flattened out. So the good news, for now, is that firms in aggregate are not passing along the surge in prices paid. Either firms are facing the reality of a loss in pricing power in a softening economic environment, and/or they are trying to wait out the current economic chaos. Either way, the underlying stagflationary pressures are roiling just under the surface for the manufacturing sector.

Note that since these measures are diffusion indices (see definition in the above chart), the magnitude of these effects is not visible. Still, given policymakers closely watch these economic surveys to inform policy, the stagflationary signals are sure to bleed out into monetary policy.

The Fed Trap

Based on the speeches from members of the Federal Reserve, the stagflationary signals are already bleeding into monetary policy. For example, concerns about stagflation appeared in Fed Chair Jerome Powell’s answers to questions in an interview at the Economic Club of Chicago last week.

“the administration…is implementing significant policy changes and particularly trade now is the focus and the effects of that are likely to move us away from our goals. So unemployment is likely to go up as the economy slows in all likelihood and inflation is likely to go up as tariffs find their way and some part of those tariffs come to be paid by the public. So that’s the strong likelihood…”

This economic bind has the Fed trapped between inflation and economic weakness. For now, all the Fed can do is hope for the best. Hope as monetary policy came through as Powell continued: “…my hope is that we’ll get through this and get back…we’ll be moving away from those goals [of maximum employment and price stability] probably for the balance of this year and then or at least not making any progress and then we’ll resume that progress as we can.”

The Fed is clearly not thinking about responding to the current economic chaos with price cuts. Powell insisted that “our role is to make sure that this will be a one-time increase in prices and not something that turns into an ongoing inflation process.” The Fed cannot contain higher prices and higher inflation expectations with rate cuts. Thus, the Fed will likely sit on its hands as long as possible in the face of weakening employment. I expect the Fed to resort to creative “Fedspeak” in lieu of action in the hopes stagflationary pressures will wind down on their own.

A GTIP Dip

Three weeks ago I made the case for buying the Goldman Sachs Access Inflation Protected USD Bond ETF (GTIP) as one way of meeting the investing challenge of a stagflationary environment. GTIP fell soon after that as long-term bond yields suddenly soared with waning confidence in the U.S. economy and the U.S. dollar. I used this period to accumulate GTIP at lower prices since I do not foresee long-term yields going much higher absent an extreme crisis of confidence. GTIP will get its next big test when April’s CPI rolls out next month. Will it demonstrate businesses restraining from passing along tariffs to end consumers? Will it warn of resurgent inflationary pressures? The Federal Reserve Bank of Philadelphia’s April 2025 Manufacturing Business Outlook Survey suggests GTIP has tailwinds.

The Goldman Sachs Access Inflation Protected USD Bond ETF (GTIP) briefly dropped toward the bottom of its recent range.

Be careful out there!

Full disclosure: long GTIP

The post An Early Look At Stagflationary Pressures appeared first on Inflation Watch.

• 2025 GDP growth at 1.5-1.9% (down from 1.8-2.2% in December)
• PCE inflation at 2.6-2.9% (up from 2.3-2.6%)
• Federal funds rate at 3.9-4.4% (up from 3.6-4.1%). These adjustments allow for minimal rate cuts this year, preserving flexibility.

Despite rising near-term inflation expectations, Powell reiterated, “We do not need to be in a hurry to adjust our policy stance and we are well positioned to wait for greater clarity.” This approach sought to reassure jittery financial markets while preserving optionality, a critical balancing act as economic chaos and uncertainty intensifies. Specifically, Powell coolly presented two potential scenarios, supposedly neither of which will trip up the Fed:

“If the economy remains strong and inflation does not continue to move sustainably toward 2% we can maintain policy restraint for longer. If the labor market were to weaken unexpectedly or inflation were to fall more quickly than anticipated we can ease policy accordingly. Our current policy stance is well positioned to deal with the risks and uncertainties that we face in pursuing both sides of our dual mandate.”

Powell further argued that inflation expectations – while rising in the short term – are not shifting over the long run:

“We do see increases widely in short-term inflation expectations and people who fill out surveys and answer questionnaires are pointing to tariffs about that. If you look in the survey world, if you look a little further out, you really don’t see much in the way of an increase. Longer-term inflation expectations are mostly well anchored.”

Powell used this argument to suggest that short-term inflationary pressures, including tariffs, should not be mistaken for a structural return to high inflation. By insisting that long-term inflation expectations remain stable, Powell steered the conversation away from stagflation and toward a more benign interpretation of recent inflation trends.

However, Powell extended these reassurances too far by parroting Treasury Secretary Bessent’s claims that tariffs are a one-time and transitory inflationary impact. Powell insisted that “it can be the case that it’s appropriate sometimes to look through inflation if it’s going to go away quickly without action by us, if it’s transitory…and that can be the case in the case of tariff inflation.” I critiqued this explanation in “The Sleight of Hand Behind the ‘One-Time Adjustment’ and ‘Transitory’ Tariff Inflation Narrative“. While a tariff can impose a one-time price adjustment, that adjustment embeds higher costs into the economy. Powell himself acknowledged that consumers remain deeply frustrated by elevated price levels, stating, “The grocery bill is about past inflation really…they’re unhappy and and they’re not wrong to be unhappy that prices went up quite a bit and they’re paying a lot for those things.” It is exactly the higher price level that formed the core of my critique of dismissing tariffs as transitory. This deft maneuver worked in the moment as no one in the press pushed back and pointed to elevated price levels as being the future concern for tariffs now.

Powell also created uncertainty about the ultimate inflationary impact of tariffs: “we also hear that people are very reluctant to allow prices to go up. At the same time we hear that businesses are intending to pass many of these prices through. So it’s hard to say how this is going to work out.” Given this uncertainty, Powell should not suggest or even hint that tariff-driven inflation could be transitory. After all, the transitory framework failed miserably in 2021.

The market reaction to Powell’s messaging will be crucial in the coming weeks. Will Powell’s deft maneuvering and lack of urgency be sufficient enough to inoculate financial markets against the on-going, surrounding policy and economic chaos of rising inflation expectations, tariff-driven uncertainty, and fragile consumer sentiment? Powell’s ability to maintain flexibility will be tested as market participants digest his messaging. The next few weeks could determine whether his balanced stance reassures investors or leaves them scrambling for clarity all over again. For now, the immediate reaction in the stock market signaled a spark of relief.

The below 15-minute chart of the S&P 500 (SPY) provides the critical price levels traders need to watch in coming days for support and resistance during this bear market. Buyers celebrated with relief upon the release of the statement but ran out of gas at the intraday high of the week as Powell concluded the Q&A with reporters.

Conclusion

Powell successfully maneuvered what could have been a challenging press conference without committing the Fed to a firm policy shift. While he downplayed stagflationary risks and sidestepped concerns about persistently high price levels, worsening economic realities could eventually force Powell and the Fed to recalibrate this strategy under far more difficult market conditions.

Be careful out there!

Full disclosure: long SPY

Note: this post was edited with the help of ChatGPT 4.0

The post Jerome Powell’s Fed Deftly Maneuvers Through a Stagflationary Minefield appeared first on Inflation Watch.

As the stock market has careened into a bear market amid growing economic anxieties and uncertainties, financial markets have started to return to the old standby to save the day: interest rate cuts from the Federal Reserve. Expectations have definitively brought forward the timing for the next rate cut from July to June. The table below the chart of the market’s target probabilities for the June Fed meeting show the change in probabilities starting one month ago. The odds for the Fed maintaining its target rate range at 4.25% to 4.5% have plunged from 49.6% a month ago to 18.3% a week ago and 18.8% yesterday. While those odds moved slightly higher to 23.1% as of the time of writing, the odds for a 25 basis point cut still increased from 56.2% to 58.1% from yesterday to now.

Of course, if the market continues to roil and sink deeper into a bear market, financial markets may become too restless with a June timetable. However, as we saw last year, just the expectation for imminent rate cuts can be enough to keep spirits lifted in financial markets.

Even if the Fed wants to placate markets and play its modern role as market hero, consumer’s rising expectations for inflation should force the Fed to remain patient and measured. March’s preliminary read for the Surveys of Consumers from the University of Michigan showed yet another increase for both short-term and long-term inflation expectations. There is already a definite upward trend in long-run expectations and short-run expectations soared. From the University of Michigan:

“Year-ahead inflation expectations jumped up from 4.3% last month to 4.9% this month, the highest reading since November 2022 and marking three consecutive months of unusually large increases of 0.5 percentage points or more. This month’s rise was seen across all three political affiliations. Long-run inflation expectations surged from 3.5% in February to 3.9% in March. This is the largest month-over-month increase seen since 1993, stemming from a sizable rise among Independents, and followed an already-large increase in February.”

In parallel with the troubling trends on inflation expectations, consumer’s expectations for more unemployment are soaring. Take together, consumers are increasingly fearing a stagflationary economic environment.

Thus, the Fed faces maximum pressure. No matter what the Fed decides or says in next week’s decision on monetary policy, major disappointment and/or jitters are bound to rise from some significant portion of observers. In turn, elevated volatility could remain elevated and translate into more pressure on stock prices. Either the Fed will be taken to task for changing a re-ignition of realized inflationary pressures, or the Fed will be criticized moving too slowly to stave off a recession.

For now volatility is calming down as fears of a government shutdown subside…

…even as one of my favorite investments and trades, SPDR Gold Trust (GLD), breaks out to fresh all-time highs.

Be careful out there!

Full disclosure: long VXX put options, long GLD shares and call spread

The post Maximum Pressure for the Federal Reserve appeared first on Inflation Watch.

For three months, the bond market has flagged stabilizing inflation starting with the Fed’s first rate cut of 50 basis points (bps). The stock market continued to rally along its uptrend lines. In parallel, the Federal Reserve signaled its second thoughts about its benigas n projections for inflation in the September Summary of Economic Projections. The stock market failed to listen and even Fed fund futures insisted on forcing the Fed into a December rate cut. The Fed delivered that rate cut with a major caveat in the December Summary of Economic Projections: hotter forecasts for inflation and economic growth and an incrementally hawkish expectation for future monetary policy rates. Accordingly, the Fed finally got the stock market’s attention as the market essentially plunged from euphoria to oversold in one day.

Long-term yields continued to increase the day of the Fed decision and the following day. The iShares 20+ Year Treasury Bond ETF (TLT) sliced right through presumed support and closed right at the low for the year set in April.

I took profits on my latest round of TLT put options last week. I will not chase TLT down here. Instead, I will wait to fade the next relief rally.

Instructive Projections

The Fed’s changes were significant but consistent with the Fed’s smoke signals and the declines in the long-term bond market.

• 2025 PCE inflation of 2.3-2.6% vs. the 2.1-2.2% September projection
• 2025 federal funds rate of 3.6-4.1% vs. the 3.1-3.6% September projection
• 2025 GDP 1.8-2.2% vs. the September projection of 1.8-2.2%

Fed Chair Jerome Powell’s commentary during the press conference was instructive. Powell left no question that the Fed sees higher inflation ahead: “these median projections are somewhat higher than in September consistent with the firmer inflation projection.” He acknowledged that under-estimating inflation this year was a partial driver of higher 2025 expectations: this year’s projections have “fallen apart as we’ve approached the end of the year”. Yet, Powell also laid the foundation and rationale for keeping a bias toward easing. He pointed reiterated that the labor market is no longer contributing to inflationary pressures and its accompanying cooling has gone far enough. Moreover, activity in the housing sector has been “weak”. Accordingly, Powell claimed that “cuts will certainly help to support economic activity and the labor market while we can still make progress on inflation because policy is still meaningfully restrictive.”

I remain skeptical. Is current policy really “meaningfully restrictive”? In his opening statement, Powell declared “with today’s action we have lowered our policy rate by a full percentage point from its peak and our policy stance is now significantly less restrictive. We can therefore be more cautious as we consider further adjustments to our policy rate.” This claim only weakly translates into “meaningfully restrictive.” Moreover, financial conditions are now almost as loose as they have ever been since the pandemic per the Chicago Fed’s Adjusted National Financial Conditions Index (ANFCI).

Sure, as one reporter in the Q&A pointed out, “we haven’t seen much change in mortgages, auto loan rates, or credit card rates.” Still, the conventional measures of financial conditions are about as good as can be in the post-pandemic era. Thus, the Fed is walking a fine line between the fear of restoking firmer than expected inflation and a labor market that is noticeably cooling. In the middle, the stock market is pricing in a perfect resolution to this dilemma even with the current plunge.

Powell’s Inflation Narrative Still Rests With the Pandemic

At several points during the Q&A portion of the conference call, Powell offered his version of inflation’s recent history, its origins and drivers. I was surprised to hear him claim that the economy is still dealing with pandemic-related disruptions that are propping up inflation. Perhaps this was a thinly veiled attempt to excuse this year’s under-appreciation of inflation’s stickiness. Powell also blamed technical factors for inflation’s stickiness: the way housing rents are calculated, lags in the data, and “temporary factors like fluctuations in used car prices.” As usual, I turned a skeptical ear toward this narrative because Powell, as he consistently does, absolved the Fed of any responsibility in aiding and abetting inflation’s stickiness by keeping rates too low for too long. I reviewed the case for why the Fed should have raised earlier in “Why Monetary Policy Was Late In Responding to the Pandemic-Era Inflation Surge“). At least this year’s experience and the learning response suggests the Fed will be more circumspect. Victory over inflation is not quite at hand yet.

The Fiscal Wildcard

Circumspection and caution should be keywords going into 2025 and beyond given the uncertainties in fiscal policy. A deepening tariff war and significant tax cuts threaten the Federal Reserve’s fragile dance with inflation-fighting. The mix of opinions within the Fed are telling. In describing how individual Fed members incorporated fiscal policy risks into their forecasts, Powell responded that some members chose to try to estimate fiscal impacts, some chose to leave out fiscal impacts, and others chose not to indicate whether they included fiscal policy. That is quite a mix! Powell made it sound like people stubbornly constructed their forecasts. Anyway, this inconsistency means that the reality of fiscal actions could drive inflation estimates even higher and cause even greater caution at the Fed.

King Dollar

The U.S. dollar (DXY) was the big post-Fed winner. Fresh strength in the U.S. dollar drove the Invesco CurrencyShares Euro Currency Trust (FXE) to a new 2-year low. This breakdown sets up FXE to eventually retest the lows from 2022. Accordingly, I am finally fully on the strong dollar bandwagon. I also expect the stock market to struggle to hit new all-time highs while the U.S. dollar makes new highs.

Is the Invesco CurrencyShares Euro Currency Trust (FXE) ready to resume a downtrend that started in earnest during the financial crisis?

YouTube video of the December 18th FOMC Press Conference

Be careful out there!

Full disclosure: long SPY put spread

The post The Federal Reserve’s “Hawkishness” Finally Gets the Stock Market’s Attention appeared first on Inflation Watch.

The stock market woke up the next day after the Producer Price Index (PPI) came in hot and suggested once again that underlying price pressures in the economy continue to increase. The S&P 500 gapped down and lost 0.5%. More importantly, TLT lost another 1.2% and confirmed a breakdown below its 50-day moving average (DMA). The core PPI, Final Demand Less Foods and Energy, has trended upwards all year and is now at its highest level since February, 2023 at 3.5%.

Source: U.S. Bureau of Labor Statistics, Producer Price Index by Commodity: Final Demand: Final Demand Less Foods and Energy [PPIFES], retrieved from FRED, Federal Reserve Bank of St. Louis, December 12, 2024.

Assuming the Federal Reserve cuts rates next week as expected, I am guessing rate cuts will slow to a crawl if not come to an outright halt for the beginning of 2025. Accordingly, the Fed’s communications to the market will get about as tricky as ever. Fortunately for the bulls the market’s momentum carries a large amount of buffer from current Animal Spirits.

iShares 20+ Year Treasury Bond (TLT)

The fascinating contrast between stubbornly stable inflation and Fed rate cuts continues to keep me fading rallies in TLT. TLT’s earlier breakout above its 50DMA (the red line below) almost fooled me. TLT is now closing the gap up created by Trump’s pick to head the U.S. Treasury department, Scott Bessent. Assuming that gap closes, a true test of the bottom of the presumed trading range should finally unfold.

Gold

While TLT delivered, gold disappointed. I have a live short-term trade in PHYS and call spreads and call options in SPDR Gold Trust (GLD) that orbits my core long-term position in GLD shares. I was encouraged by GLD’s reaction to the CPI and just assumed the rally would continue into at least the end of this week. Instead, GLD reversed right back to 50DMA support. I do not have a ready hypothesis to explain this seemingly contrarian move. (I would love to hear yours!)

What Happens If the Fed Gets “Hawkish”

The Fed is currently dovish. It would not take much for the Fed to sound hawkish. A firm follow-up to the round of Fedspeak attempting to walk back market expectations for rates cuts could set off the alarm bells for the market. At that point, the short-term GLD trade gets less attractive. TLT will probably still be good for fades. The stock market will likely stall for at least the rest of the Santa rally season….just enough time to find the next reason to reinflate Animal Spirits.

The big wildcard for me in a “more hawkish Fed” scenario is the U.S. dollar. There are multiple countervailing catalysts that make the U.S. dollar attractive and unattractive. Thus, it is hard to develop conviction beyond the short-term technicals. Right now, I still like fading the euro against the U.S. dollar. At the same time, I finally gave up trying to catch a pullback in USD/CAD, a strengthening in the Canadian dollar (Invesco CurrencyShares Canadian Dollar Trust (FXC)). I am now playing the major breakout to the long side. USD/CAD is practically making a beeline to test a critical long-term double-top spanning 2016 and 2020.

Be careful out there!

Full disclosure: long USD/CAD, short EUR/USD: long GLD shares, calls, and call spread; long PHYS, long TLT puts

The post Bonds Try to Weigh on A Market Trying Harder to Look Past Stabilizing Inflation appeared first on Inflation Watch.

“A strategy of repeatedly lowering the fed funds target range toward a more neutral level relies on confidence that the neutral level is materially lower than where rates are now. When I look at the available evidence, though, I see substantial signs that the neutral rate has increased in recent years, and some hints that it could be very close to where the fed funds rate is now…ces. I anticipate the FOMC will most likely need more rate cuts to finish the journey. But it’s difficult to be sure how many cuts may be needed and how soon they may need to happen.” – Navigating in shallow waters: Monetary policy strategy in a better-balanced economy, Dallas Fed President Lorie K. Logan, November 13, 2024

“Shifting from my baseline to alternative scenarios, recent information suggests to me that the risk of inflation ceasing to converge toward 2%, or moving higher, has risen, while the risk of an unwelcome deterioration in the labor market has remained unchanged or possibly fallen.” – Musalem: Remarks on Monetary Policy and the U.S. Economic Outlook, St. Louis Fed President Alberto Musalem, November 13, 2024

“While now is the time to begin dialing back the restrictiveness of monetary policy, it remains to be seen how much further interest rates will decline or where they might eventually settle.” – Longer-term Considerations for Growth and Monetary Policy, Federal Reserve Bank of Kansas City President and Chief Executive Officer Jeff Schmid, November 13, 2024

All three speeches included Fedspeak for caution on the pace of rate cuts while maintaining the flexibility to follow the data. These speeches also came on the same day as the release of the October CPI data. This timely convergence of caution and circumspection is important because core CPI maintained the stabilization trend in place since a low in July (see the green line below). Meanwhile, core PCE, the Fed’s favorite indicator of inflation also looks like it is stabilizing. In other words, it seems the Fed is paying attention to stabilizing inflation patterns.

Sources: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average [CPILFESL], retrieved from FRED, Federal Reserve Bank of St. Louis, November 13, 2024. U.S. Bureau of Economic Analysis, Personal Consumption Expenditures Excluding Food and Energy (Chain-Type Price Index) [PCEPILFE], retrieved from FRED, Federal Reserve Bank of St. Louis, November 13, 2024.

Shelter costs continue to drive the bulk of inflation. For October, shelter costs constituted 65% of the year-over-year increase in the CPI. Housing costs are in a paradoxical juncture where monetary policy could help maintain elevated housing costs no matter where interest rates go. The National Assocation of Homebuilders (NAHB) laments that high interest rates contribute to contraints on supply thourgh an expensive and difficult financing environment for construction loans. On the other hand, looser monetary policy could reignite a housing demand that strains supply further and drives up prices. For now, a surprise rebound in mortgage rates is tamping down housing demand.

A Friendly Message from Gold?

While inflation is stabilizing, gold may have topped out.

Two months ago I interpreted the strength in gold as indicative of a skepticism about the Fed’s implied victory message on inflation. That trend persisted until last week. The resolution of the U.S. presidential election generated a fresh surge in Bitcoin (BTC/USD) and presumably drained interest in gold. The SPDR Gold Trust (GLD) gapped down and lost 3.0%. I was hopeful that the 50-day moving average (DMA) (the red line below) would hold as support. As a (perma) bull on gold, I added call options to supplement my core GLD position. Today’s 1.0% loss in GLD further confirmed a 50DMA breakdown. This bearish technical signal means that I am unlikely to try new short-term trades for a while.

Source for charts: TradingView.com

The new inverse correlation between gold and Bitcoin indicates a sharp shift in preferences with Bitcoin getting an added advantage from expectations of a pro-crypto regulatory regime starting next year.

The Bond Market Remains Wary

Two months ago I claimed that the bond market acted wary about the Fed’s presumed victory over inflation. Sure enough, long-term yields have steadily risen ever since. The iShares 20+ Year Treasury Bond ETF (TLT), which goes up when long-term interest rates go down, is now trading near the bottom of a presumed horizontal trading range. My strategy to fade TLT has worked all the way down.

After TLT gapped up for some reason on the CPI news, I thought I missed my latest profit opportunity. So when TLT faded back to the previous day’s close, I counted myself fortunate and took profits on my latest round of TLT put options. TLT then went on to lose 1.0% for the day.

The U.S. dollar soars

The U.S. dollar index (DXY) has benefited from one tailwind after another. Now, the presumed tailwind comes from the boost it should get with increased tariffs that also promise to prop up inflationary pressures in the economy. Fewer dollars going overseas to buy goods tips the supply/demand balance in favor of a stronger dollar. Two months ago I decided to bet on continues strength in the British pound versus the U.S. dollar by buying shares of Invesco CurrencyShares® British Pound Sterling Trust (FXB). I took the opportunity to buy when FXB tested its uptrending 50DMA. The currency ETF has continued downward from there with little sign of an imminent rebound.

Conclusion

With the Presidential election behind us, the bets on stabilizing (or even stronger) inflation are clarified for now: long Bitcoin, long gold only after Bitcoin enthusiasm wanes somehow, long U.S. dollar, and short TLT. While I sold all my Bitcoin earlier in the day, I will continue to trade by buying dips. I am conflicted on the U.S. dollar as I stubbornly hold some dollar shorts while trading in and out of dollar longs. At some point, I will commit to a dollar long by shorting EUR/USD. Europe stands to lose in the next administration with a weaker NATO, more contentious relationships, and higher tariffs in a weakening economic backdrop.

The Federal Reserve has ahead as precarious a path as ever while it gets increasingly wary about stabilizing inflation!

Full disclosure: long GLD shares and calls, long PHYS, long FXB

The post The Federal Reserve Is Paying Attention to Stabilizing Core Inflation appeared first on Inflation Watch.

Most telling in today’s performance was Powell’s dance around the questions trying to reconcile the economic forecasts with the rate forecasts. They seem inconsistent at best and make little sense at worst: one rate cut and no further progress on inflation (core PCE (Personal Consumption Expenditures)). The quotes below come from Powell’s introductory remarks.

• A midpoint expectation for one rate cut in 2024: “If the economy evolves as expected, the median participant projects that the appropriate level of the federal funds rate will be 5.1 percent at the end of this year, 4.1 percent at the end of 2025, and 3.1 percent at the end of 2026.” Note that the current rate is set to 5.25% to 5.50%. March’s median projection was 4.6% for year-end.
• Core PCE projection for 2024 increased from March’s 2.6% to 2.8% for 2024 and going to 2.0% in 2026. Core PCE has shown no downward momentum yet this year. It has gone from 2.9% in January to 2.8% from February through April. Thus, the Fed expects no further progress on inflation this year.
• The Fed made no changes to its GDP growth forecasts: 2.1% this year, and 2.0% for the next two years.
• The Fed made a slight change to its unemployment forecast. This year stayed at 4.0%. The rate went from 4.1% to 4.2% next year and from 4.0% to 4.1% in 2026.

Put it all together, and it is not clear why the Fed wants to cut rates at all this year. I made this point last month in “Fed’s Powell Avoids Rate Cut Talk While April CPI Keeps Hope Alive” and in March in “Financial Conditions Make A Monetary Roundtrip and Undercut the Need for Rate Cuts“. Now, with no forecasted progress in core PCE inflation for this year, the Fed seems to risk sticky inflation staying sticky for longer if it cuts rates before seeing the “sustained progress” Powell talks about ad nauseam. In this latest round, Powell repeated the policy principle yet again: “we don’t think it’ll be appropriate to reduce rates and begin to loosen policy until we have more confidence that inflation is moving back down to 2% on a on a sustainable basis and that’s the that’s the test we’ve applied”.

When Powell was asked about the conundrum, I expected him to untangle the problem by indicating these forecasts are interdependent and assume that the underlying economic mechanisms that connect all these factors work out as expected. For example, one hypothetical would be a world without a rate cut in 2024 which undermines the rosy projections for GDP and employment. Instead, Powell essentially undermined the meaningfulness of the forecasts.

Powell began by explaining away the sticky core PCE with a technical discussion about lapping lower readings from last year. He essentially suggested that the sticky core PCE is an artifact of tough comparables and thus not as meaningful as it seems at first glance. More baffling was Powell’s attempt to reconcile a year-end forecast that is higher than analyst forecasts for core PCE in May while at the same time forecasting a rate cut:

“it’s a forecast a fairly conservative forecast month by month that would lead to slightly higher…12 months rates by the end of the year if we get…better ratings than that then you will see that come down or remain the same. If you’re at 2.6 2.7 [for May] you know that’s that’s a really good place to be.”

In other words, this last lonely rate cut rushing toward the departure gate looks like the Fed’s fleeting attempt to throw the market a bone and deliver permission to continue to rally in anticipation of a rate cut cycle.

The Teflon S&P 500

The S&P 500 went into the Fed announcement at all-time highs and trading well above its upper Bollinger Band (BB) (the black lines defining price volatility in the chart below). From a technical perspective the S&P 500 is in an extremely stretched position to the upside. The small fade into the close still left the index quite stretched (short-term) to the upside.

The market gapped up in the morning presumably on a favorable print for the CPI (Consumer Price Index). However, while Powell acknowledged the positive development, he still threw cold water on the idea that this report finally gave the Fed permission to proceed with rate cuts:

“…we see today’s report as progress and as you know building confidence, but we we don’t see ourselves as having the confidence…that would warrant beginning to loosen policy.”

I am impressed the S&P 500 held on to any gains for the day. Then again, the index, and the stock market in general, has over the course of time acted like teflon against the on-going slippage in the forecast for lower rates.

The Trapped Bond Market

The stock market’s teflon has occasionally emerged tarnished by rising long-term bond yields. The breakout (lower yields) for iShares 20+ Year Treasury Bond ETF (TLT) earlier in June paved the way for the latest phase in the stock market’s rally. Yet, the S&P 500 did not come down with a pullback to the previous downtrend channel. TLT’s fade from last week’s high, as Powell made the case for a dovish hawkishness, may set the stage for a new trading range that traps the bond market in a new sideways trading channel. If so, the S&P 500 can detach more clearly from the machinations in yields. To-date, the on-going expectations for rate cuts has been an important driver helping the S&P 500 eventually recover from fears over long-term bond yields even as market breadth has waned.

In the meantime, I bought TLT put options as a trade on the presumed, new range.

Be careful out there!

Full disclosure: long TLT puts, long SPY puts and put spread

The post Fed’s Powell Avoids the Obvious: Inflation and Interest Rate Forecasts Make Little Sense appeared first on Inflation Watch.

I break down the key components of Powell’s observations (using the transcript from the CNBC TV recoding of the live event) and then juxtapose them with the prospects for inflation going forward.

The S&P 500 (SPY) since the October lows overlayed with my past short-term trading calls. (Source: Tradingview.com)

Is Policy Really Restrictive?

Powell observed that “the labor market is about as tight as it was before the pandemic in 2019, and that’s good. Real wages are now positive, and unemployment has been below 4% for 27 consecutive months, something that hasn’t happened in half a century. So, the labor market is very strong, with signs of gradual cooling and rebalancing, so that the supply and demand for workers are coming back into balance, just as we would want.” The logic did not make sense at first. Powell provided the evidence of balance in the labor market later on in the discussion. He noted that “the ratio of vacancies to unemployed people, for example, has gone from more than 2 to 1 to now 1.3 to 1, and it was 1.2 before…You also see wages coming down, and you see quits coming down.” Most importantly, Powell used these observations as evidence that “policy is probably restrictive.”

Powell went on to add that restrictive policy is weighing on rate-sensitive spending. However, the conventional indicators of financial conditions still show they are just as loose as they were before the Fed started hiking, January 28, 2022 to be exact. In other words, either the market has done some serious advanced front-running of rate cuts or current policy is not nearly as restrictive as the Fed thinks. Even the stock market’s all-time highs suggest monetary conditions are not tight. From the Federal Reserve Board of Chicago’s National Financial Conditions Index (NFCI) (follow the black line for ANFCI):

Even the hand-wringing this year from the Federal Reserve about resilient inflation implies that policy may not be restrictive enough (whether that means rate hikes, or, more likely, extending the time horizon for current rates).

Resilient Inflation

Powell repeated a familiar refrain about inflation not falling as fast as expected given presumed restrictive policy. Thus, Powell had to show deference to the possibility that today’s high rates will need to stay in place longer than expected:

“The first quarter in the United States was notable for its lack of further progress on inflation. We had higher readings in the first quarter, higher than we expected. We did not expect this to be a smooth road, but these were higher than I think anybody expected. So, what that has told us is that we’ll need to be patient and let restrictive policy do its work.”

This comment tells me rate cuts are nowhere on the horizon. Moreover, Powell noted “we have the highest interest rates in some time. It may be that it takes longer than expected to do its work and bring inflation down.”

Most telling were Powell’s words when a question offered the opportunity to reassure the market that rate cuts were still on the way. Emphasis mine:

“So, as I just mentioned, I do think it’s really a question of keeping policy at the current rate for a longer time than had been thought. By many measures, the policy rate is restrictive. The question is, is it sufficiently restrictive? And I think that’s going to be a question that time will have to tell. Entertain the possibility? That could be a very small probability, but I have said that I don’t think it’s likely based on the data that we have that the next move we make would be a rate hike. I think it’s more likely that we’ll be at a place where we hold the policy rate where it is.”

Note what Powell did NOT say: it’s more likely that rates will be lower by the end of the year (or even next year).

So, nowhere in the discussion did Powell provide a line for the market expect rate cuts anytime soon. Thus, he has primed the market to get excited about any soft data that could provide the seeds of an excuse for the Fed to cut rates. Powell’s positioning is made even more potent by the stock market’s ability to trade at all-time highs despite all the hand-wringing about inflation this year.

Inflation Forecast

Powell expressed a lot of uncertainty about the path for inflation despite his confidence that “we will do that, that we will get inflation down to 2%.” I am not sure how rate cuts help bring down inflation (Turkey sure learned a central bank cannot cut rates to lower inflation), so I have to assume Powell has an image of “higher for longer” monetary policy rates.

Responding to a question on whether inflation could end up being more persistent than expected, Powell said: “I think we need more than a quarter’s worth of data to really make a judgment on that.” It’s like the perpetual data delay. It will be interesting to hear whether April’s inflation data finally gives the Fed more confidence that inflation is coming down sustainably. Time is running out for the Fed to start telegraphing the first rate cut, so the pressure is on the Fed to spin a story about April and May inflation that points to the 2% target.

When I look a the core CPI graph (year-over-year percentage change in the price index), it looks like inflation will soon resume a steep descent. To apply a modicum of extra rigor, I ran a simplistic forecast through ChatPGT’s Data Analyst. I let the model pick its forecasting method. This is a very simplistic forecast because it only uses the aggregate CPI time series. A more accurate forecast would consist of aggregating the forecasts of individual components of core CPI.

I provided the model core CPI (measured year-over-year) data back to 2016. I wanted the model to surmise that “equilibrium” consists of a tight range for inflation. I did not provide any more data because I figured the further away history gets from the pandemic era, the less likely the model has any value (another downside of using a single, aggregated time series for the forecast).

The chart below combines the actual core CPI data with the forecast. The “funnel” around the forecast shows the confidence interval within which inflation will fall in the future at 95% certainty. The wide swath of possibilities is consistent with Powell’s uncertainty about the path ahead. The flat average forecast is a typical behavior of time series forecasting where there are no definitive seasonal effects detected or modeled future episodic events. (For you ChatGPT and statistics wonks, I provide an Appendix below where ChatGPT explains the model and justifies its approach).

Source: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average [CPILFESL], retrieved from FRED, Federal Reserve Bank of St. Louis; May 15, 2024.

The Bond Market Rules

Putting aside vain attempts to forecast future inflation, the bond market is the ultimate arbiter of inflation expectations and/or how inflation may impact interest rates. The bond market in the form of the iShares 20+ Year Treasury Bond ETF is at a very critical (technical) juncture. The downtrend in TLT (uptrend in rates) was the ultimate guide in pushing the market into its April correction. The rebound in stocks for May perfectly correlates with the rebound in TLT (lower rates). The “soft” April CPI report sent TLT up 1.4% and right up against the top of the downtrend channel.

iShares 20+ Year Treasury Bond ETF (Source: TradingView.com)

A confirmed breakout with a higher close should open the floodgates of bullishness for the stock market. A failure at resistance from the upper part of the channel could trigger a false breakout for the indices. Thus, given this year’s correlation with stocks, I reloaded on TLT puts as a hedge on my long trading positions.

Overall, the lesson in all these dynamics is that inflation combined with the interest rate response should continue to dominate the market’s underlying narrative. With rates on hold, even the Fed is just along for the ride for now.

Be careful out there!

Appendix (ChatGPT explains and justifies the CPI forecast)

{the following is verbatim including ChatGPT’s musings on data types and fixing its own processing problems}

The data consists of monthly core CPI year-over-year percentage changes starting from January 2016. To project the CPI for the next 24 months, I will use the ARIMA (AutoRegressive Integrated Moving Average) model, which is well-suited for time series forecasting.

Justification for ARIMA Model:

1. Handling Trends and Seasonality: ARIMA can model both trend and seasonality in the data, which is crucial for accurate CPI forecasting.
2. Flexibility: The model can be adjusted to different time series characteristics through its parameters.
3. Proven Effectiveness: ARIMA has been widely used and tested in economic and financial forecasting, making it a reliable choice.

Steps for the Analysis:

1. Data Preparation: Convert the date column to a datetime format and set it as the index.
2. Stationarity Check: Perform tests to check if the time series is stationary. If not, apply differencing.
3. Model Identification: Use autocorrelation (ACF) and partial autocorrelation (PACF) plots to identify the order of the ARIMA model.
4. Model Estimation: Fit the ARIMA model to the data.
5. Forecasting: Generate forecasts for the next 24 months.
6. Confidence Intervals: Calculate confidence intervals for the forecasts.
7. Visualization: Plot the actual data, the forecasted values, and the confidence intervals.

Let’s start with the data preparation and initial analysis. ​​

The Augmented Dickey-Fuller (ADF) test results are as follows:

• ADF Statistic: -0.988
• p-value: 0.758
• Critical Values:
  • 1%: -3.508
  • 5%: -2.895
  • 10%: -2.585

Since the p-value is greater than 0.05, we fail to reject the null hypothesis that the time series is non-stationary. This indicates that the series needs to be differenced to make it stationary.

Let’s apply first-order differencing and recheck for stationarity. ​​

The ADF test results after first-order differencing are as follows:

• ADF Statistic: -2.447
• p-value: 0.129
• Critical Values:
  • 1%: -3.509
  • 5%: -2.896
  • 10%: -2.585

The p-value is still greater than 0.05, indicating the time series is not yet stationary. Let’s apply second-order differencing. ​​

The ADF test results after second-order differencing are as follows:

• ADF Statistic: -2.843
• p-value: 0.052
• Critical Values:
  • 1%: -3.509
  • 5%: -2.896
  • 10%: -2.585

The p-value is now close to 0.05, indicating the time series is approaching stationarity. Since it’s marginally above the threshold, we will proceed with ARIMA modeling with second-order differencing.

Model Identification

Next, we’ll use ACF and PACF plots to identify the appropriate orders (p, d, q) for the ARIMA model. ​​

The ACF and PACF plots provide insights into the appropriate orders for the ARIMA model:

• ACF (Autocorrelation Function): The ACF plot shows significant lags at various points, suggesting that an MA component (q) might be needed.
• PACF (Partial Autocorrelation Function): The PACF plot shows significant lags at the beginning, suggesting that an AR component (p) might be necessary.

Given the plots, an ARIMA model with orders (p, d, q) will be selected. Based on visual inspection, we can start with ARIMA(2, 2, 2) since both ACF and PACF show significance up to lag 2.

Model Estimation

Let’s fit the ARIMA(2, 2, 2) model to the data and generate forecasts for the next 24 months. ​​

It seems there’s an issue with the data types in the forecast confidence intervals, which might be causing the error. Let’s inspect the forecasted values and the confidence intervals to identify the problem. ​​

The forecasted values and confidence intervals appear to be valid. The issue might be due to incorrect data handling during the plotting process.

To resolve this, let’s explicitly convert the confidence intervals to a numeric type before plotting. ​​

It appears the error persists despite converting the confidence intervals to float. This might be due to a mismatch in the indices of the forecast intervals and the forecasted mean.

To resolve this, I’ll ensure the indices of the confidence intervals match those of the forecasted mean before plotting. ​​

The issue may be due to an incompatibility between the data types of the forecast index and the confidence intervals. To resolve this, I will ensure all data is in the correct numeric format and use the correct plotting function.

I’ll convert all relevant data to the same data type and then re-plot. ​​

The plot now correctly displays the actual data, the forecast, and the confidence intervals.

Summary of Analysis and Forecast:

• Data Preparation: The time series data was checked for stationarity and transformed using differencing to achieve stationarity.
• Model Selection: Based on the ACF and PACF plots, an ARIMA(2, 2, 2) model was chosen.
• Model Fitting and Forecasting: The ARIMA model was fit to the data, and forecasts for the next 24 months were generated.
• Visualization: The actual data, forecasted values, and confidence intervals were plotted to provide a comprehensive view of the projected CPI.

This approach provides a robust forecast by incorporating both autoregressive and moving average components, accounting for trends and seasonality in the core CPI data. The confidence intervals offer a range of possible future values, helping to understand the uncertainty associated with the predictions.

Full disclosure: long SPY calendar call spread, long TLT puts

The post Fed’s Powell Avoids Rate Cut Talk While April CPI Keeps Hope Alive appeared first on Inflation Watch.

I am tempted to say financial markets have already done the Fed’s work. However, it is very likely that the minute the Federal Reserve even hints that rate cuts could be delayed until next year, the resulting tantrum in financial markets could be epic. The Fed is loathe to disappoint markets, and the message from the last meeting and subsequently from Jerome Powell has been to promise a rate cut sooner than later. Financial markets have persistently focused on any and all dovish twinges in Fed-related pronouncements. For example, from Powell’s testimony to Congress on March 6th (emphasis mine):

“We believe that our policy rate is likely at its peak for this tightening cycle. If the economy evolves broadly as expected, it will likely be appropriate to begin dialing back policy restraint at some point this year. But the economic outlook is uncertain, and ongoing progress toward our 2 percent inflation objective is not assured. Reducing policy restraint too soon or too much could result in a reversal of progress we have seen in inflation and ultimately require even tighter policy to get inflation back to 2 percent. At the same time, reducing policy restraint too late or too little could unduly weaken economic activity and employment.”

Powell can insert all the standard caveats he wants. Markets read this statement as saying rate cuts are on their way!

A Nervous Bond Market

Yet, bond markets have been a little “nervous” all year. For example, the iShares 20+ Year Treasury Bond ETF (TLT) has trended downward (meaning higher bond yields) so far this year with lower highs and lower lows. From TradingView:

TLT is just a fresh low of the year away from finally catching the stock market’s attention again.

Copper, Lumber, and Oil – oh my!

The bond market has good reason for some jitters. Several commodities have sprung back to life this year. Copper miner Freeport-McMoRan Inc (FCX) is welcoming the upcoming Fed meeting with a 7+ month high. FCX is up 19.8% in less than two weeks. (FCX has been stuck in a trading range since the beginning of 2021).

Lumber bottomed out in early 2023. This month, lumber broke out above last summer’s high and is back to levels last seen in August, 2022.

Oil, everyone’s favorite non-core component of inflation, has been in “stealth” rally mode all year. The United States Oil Fund, LP (USO) looks ready to launch parabolically on the wings of rate cuts.

Where will these prices go with rate cuts? I vote higher.

The Golden Touch

Speaking of getting ready for rate cuts, gold, my favorite hedge enjoyed a spectacular (and overdue) breakout this month. SPDR Gold Shares (GLD) traded at an all-time high at its peak this month.

I like buying the dips in GLD going forward. The odds seem sufficiently high for the Fed to feel “forced” into easing into a sea of market liquidity.

Straining to See the Weakness in Labor Markets

So maybe the Fed can strain its economic gaze and find an excuse to do a “proactive” rate cut. The graph below shows the unemployment rate has likely bottomed out (left axis and blue line) Yet, it remains near historic lows. Initial unemployment claims have been trendless with a recent peak set last summer (right axis and green line). Finally, real GDP quarter-over-quarter growth has levitated in positive territory and for the last two years has defied overly persistent expectations for a recession (right axis and red line). From my perch, I see no excuse for a rate cut here, but perhaps I am not creative enough with the data.

Sources: U.S. Bureau of Labor Statistics, Unemployment Rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis; U.S. Employment and Training Administration, Initial Claims [ICSA], retrieved from FRED, Federal Reserve Bank of St. Louis; U.S. Bureau of Economic Analysis, Real Gross Domestic Product [GDPC1], retrieved from FRED, Federal Reserve Bank of St. Louis.

The Stock Market’s Giddy Anticipation

The stock market’s giddy anticipation of rate cuts is poetic. The stock market has soared on loosening financial conditions and has been able to ignore just about any bad news the macro environment tries to toss out there. Recent successive all-time highs speak volumes to the buffer the Fed can enjoy if it so chooses to wait out the Presidential election before making changes to monetary policy.

Conclusion

With market breadth increasingly lagging the stock market’s ascension, I have been a skeptic about the overall rally for several weeks. The Federal Reserve is probably the last catalyst between now and the Presidential election that has a chance of validating my skepticism. If the Fed complies with the market’s giddiness, there is no telling how high the market could soar in coming months. If the Fed decides to wait things out, the stock market will lose a major contributor to the upward and higher fund. Then again, maybe the Fed pulls off a magical “hawkish rate cut” (one and done rate cut with a warning about the potential for inflation to rise from the ashes). The Fed could figure out just the right balance between disappointing the stock market and fueling ever increasing levels of speculation and higher commodity prices…

Be careful out there!

Full disclosure: long GLD

The post Financial Conditions Make A Monetary Roundtrip and Undercut the Need for Rate Cuts appeared first on Inflation Watch.

This admonition is unsurprising given Macklem’s general reluctance to declare victory over inflation. While the Bank of Canada increasingly sees the elements needed to get inflation back down to 2%, Macklem stated that “we are not there yet.” They need to see sustained and further (for “a number of months”) downward momentum in core inflation.

Cautious About the Signs of Victory Over Inflation

December’s statement on monetary policy also reflected the Bank of Canada’s wavering. The statement estimated that “data and indicators for the fourth quarter suggest the economy is no longer in excess demand. The slowdown in the economy is reducing inflationary pressures in a broadening range of goods and services prices.” These conditions should have generated a declarative victory statement. Instead, the Bank of Canada proceeded to posture staunchly against inflation: “Governing Council is still concerned about risks to the outlook for inflation and remains prepared to raise the policy rate further if needed. Governing Council wants to see further and sustained easing in core inflation, and continues to focus on the balance between demand and supply in the economy, inflation expectations, wage growth, and corporate pricing behaviour.”

Still, in the interview, Macklem acknowledged that rates are likely to start coming down in 2024. He just refused to provide a timetable.

The Soft Landing

The interviewer pointed out that the scenario Macklem portrays sounds like a “soft landing” for the economy. Macklem was careful not to use that term. Instead he pointed out that much of the adjustment in the labor market has come through a reduction in vacancies instead of a large rise in unemployment. An anticipated weakness in growth for the next 2 to 3 quarters should not generate a “deep” recession. Macklem directly claimed that “we can get inflation back to 2% without a recession.”

This year will be a transition year. By the end of the year, the economy should be in soft landing mode if all goes well.

The Canadian Dollar

The Bank of Canada released its December statement on monetary policy just as the U.S. dollar was experiencing a slight relief rally against the Canadian dollar (USD/CAD) (or the Invesco CurrencyShares Canadian Dollar Trust (FXC)). The slide resumed with the Federal Reserve’s decision on monetary policy the following week and the resulting celebration over the implicit announcement that inflation in the U.S. is dead. I had long anticipated the decline at the time with a target of testing the lower part of a trading range in place since September, 2022.

After taking profits, I am back to accumulating a short position. I expect the Bank of Canada’s on-going caution and the Bank’s refusal to get dovish to act as a tailwind for the Canadian dollar. The chart below from TradingView.com shows volatility in USD/CAD distinctly driven by key events. The Bank of Canada’s next Monetary Policy Report will come on January 24th. The Fed comes around the week after.

So, overall, I continue to favor playing the trading range in USD/CAD as an eventual trip to or toward the bottom of the range. I currently cannot foresee catalysts that will push the currency pair to stray too far away from the range. If USD/CAD escapes the range, I think the odds favor a breakdown over a breakout.

Be careful out there!

Full disclosure: short USD/CAD

The post Bank of Canada’s Macklem: The End is In Sight But Rates Are Not Returning to Pre-Pandemic Levels appeared first on Inflation Watch.