I faded the move in bonds as nothing about the December CPI print changed the fundamental narrative of sticky inflation and a cautious Fed or even the prospect of soaring U.S. budget deficits. I speculated on weekly SPY put options as a hedge. I fully acknowledge that the stock market has spent a year and a half or more adjusting to every hiccup and bout of angst over the inflation narrative.

The chart below demonstrates that the eye must strain hard to see a change in the profile of core CPI. We will have to wait until later this month to see whether the softer than expected core CPI also bends core PCE off its uptrend from its last trough.

Sources: 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; 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; January 15, 2025.

The volatility index (VIX) well represented the stock market’s huge sigh of relief over inflation. The VIX plunged 13.9% and brought an end to the most recent uptrend.

Shelter Inflation Continues Trending Down

Shelter inflation, along with services inflation, has been a key culprit in stubbornly sticky inflation. The National Association of Home Builders (NAHB) pointed out that “the year-over-year change in the shelter index remained below 5% for a fourth straight month and posted its lowest annual gain since January 2022, suggesting a continued moderation in housing inflation.” Shelter inflation has even been on a definitive downtrend since peaking in March, 2023. Unfortunately, the current trajectory may be too slow for comfort in terms of its impact on aggregate core CPI.

Shelter inflation dropped from 7.5% in December, 2022 to 6.2% in December, 2023 and now 4.6% last December. If this nearly linear pace continues, shelter inflation will be around 3.2% next December, right around where core CPI currently sits. Thus, other components will still need to do some heavy-lifting in coming months to meaningfully push core CPI, and presumably core PCE, closer to the Fed’s 2.0% target.

Source: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: Shelter in U.S. City Average [CUSR0000SAH1], retrieved from FRED, Federal Reserve Bank of St. Louis; January 16, 2025

An Oil Breakout

Oil prices are not part of the core CPI, but its recent breakout has caught my attention. A continued, persistent rise in oil prices could bleed into higher inflation expectations for consumers. Such a dynamic may further motivate the Federal Reserve to sit on its hands with monetary policy. A 3.3% gain in the United States Oil Fund (USO) sent the ETF to a 2 1/2 year high.

A Spike In Short-Term Inflation Expectations?

Every month, the New York Federal Reserve publishes a survey of consumer expectations. This survey includes various measures of inflation expectations. The 1-year median expected inflation rate for consumers stayed around 3.0% for all of 2024, consistent with the narrative of sticky inflation. However, a potentially interesting blip happened in December where the median point prediction jumped from 3.0% to 3.8%. The median point predictions are typically higher than the median expected inflation rate, but they rarely diverge and almost never by such a wide margin. The accompanying press release does not refer to this surprising 1-month behavior, but I cannot help speculating on its significance. I will be watching to see whether this point projection manages to lead the median expected inflation rate higher or whether it snaps back to the typical relationship. Either way, such a jump is surely not positive for inflation in the near-term.

The Trade

I continue to maintain a strategy of fading rallies in TLT. Going into the CPI I owned a single February TLT $85 put option “just in case” CPI produced a fresh upside surprise in inflation. Now I can accumulate TLT put options at more attractive prices. TLT’s rally stopped just short of resistance at the 20-day moving average (DMA) (the dotted line below). A breakout from there will set up even more attractive prices on a test of converging resistance between the downtrending 50DMA (the red line) and the bottom of the former trading range (the thick black line).

Be careful out there!

Full disclosure: long TLT put options, long SPY put options

The post A Fresh Opportunity to Fade Bonds As A Marginal Change in Inflation Ignites A Near Oversold Market 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.

The Bank of Canada is worried about higher energy prices, “structural pressures” in the housing market primarily related to supply shortages (which it acknowledged must first be addressed on the supply side), and “persistence in underlying inflation.” This underlying inflation consists of elevated “near-term inflation expectations and wage growth” and corporate pricing decisions that are “normalizing only slowly.” Core inflation on a year-over-year basis has come down, but the 3-month view shows little downward momentum. Accordingly, the Bank of Canada put the country on notice that it is leaving the door open to future rate hikes because of the stubborn uncertainty in getting inflationary pressures down.

Yet, the BoC did not proceed with a rate hike. Counterbalances to the increased inflation risks remain. Overall supply and demand in the Canadian economy is almost in balance with the trend favoring excess supply. The BoC also downgraded its outlook for economic growth because the economy slowed more than expected back in July; less excess demand exists than expected.

So while the BoC hiked its expectation for inflation from 3% to 3.5% for next year, the central bank is sticking to its longer-run projection of 2% in 2025. Thus, Macklem felt confident in reassuring Canadians: “with clearer evidence that monetary policy is working, Governing Council’s collective judgment was that we could be patient and hold the policy rate at 5%.“ Interest rates will stay higher for longer and the inflation target remains in sight.

Corporate and Government Behavior Working Against Monetary Policy

Companies and Canadian governments in aggregate are not cooperating with the objectives of monetary policy.

Canadian companies are still passing along price increases to consumers faster than normal. From the Monetary Policy Report:

“Corporate pricing behaviour has yet to normalize. Businesses continue to increase prices more frequently and by a larger amount than normal… This may indicate that households and businesses are, respectively, expecting to pay more and charge more for goods and services. High inflation expectations could also feed into wages.”

I assume this dynamic also comes from lingering excess demand which makes consumers less price sensitive. The coming era of excess supply should work counter to this effect.

During the Q&A Macklem pointed out that the fiscal spending plans are working against monetary policy. Aggregate government plans will grow spending by 500 basis points greater than the potential growth of the Canadian economy. Thus, the economy will add more demand than supply. In the past year, growth in government spending was below 2%. Macklem indicated that it would be helpful if fiscal and monetary policy were “rowing together.” The BoC’s forecasts take into account the potential future inflationary pressure from government spending.

The Canadian Dollar Trade

The bump higher in hawkish rhetoric did not benefit the Canadian dollar, perhaps because the BoC maintained its longer-term expectation for inflation. Weakness in the currency Invesco CurrencyShares Canadian Dollar Trust (FXC) or strength in USD/CAD continued until the Federal Reserve’s last policy announcement. Financial markets painted a dovish interpretation to the accompanying news even though it read like nothing materially changed.

I did not expect the drift higher (with high volatility) in USD/CAD as I accumulated a short position. I continue to hold the position as I see two main factors working against my thesis reaching their own individual extremes.

The biggest shift against my original setup was a big increase in the spread on 10-year yields between U.S. and Canadian bonds. Just over a month ago this spread sat at a level that looked like a potential bottom. Shortly thereafter, the bottom dropped out. The spread was last this wide back in March, 2019. This large spread serves advantage to the U.S. dollar over the Canadian dollar. From World Government Bonds:

Oil has also worked against my original thesis. Oil did not stabilize. While it soon spiked higher in response to Hamas’s attack on Israel, selling in oil resumed in about 10 days. Last week, the United States Oil Fund, LP (USO) hit a 3+ month low. While this decline should reduce the Bank of Canada’s fear that higher energy prices will bleed their way into pressures on core inflation, it also works against the Canadian dollar as a commodity currency. I have dropped any expectation on oil although I am net short USO. From TradingView.com:

From a technical perspective, USD/CAD remains well-supported by its uptrending 50-day moving average (DMA) (the red line below). I still expect this uptrend to break to the downside as the extremes working against the Canadian dollar lose steam. To the upside on USD/CAD I have a clear stop loss point above the peak created by the reaction to the Federal Reserve’s November 1st announcement on monetary policy. From TradingView.com:

Be careful out there!

Full disclosure: short USD/CAD, net short USO (short shares, long call spread)

The post Canada’s Version of Higher for Longer: Inflation Risks Have Increased appeared first on Inflation Watch.