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The retail sales data for January was strong and shows that the US consumer is not slowing down, see charts below. This is not surprising with a strong labor market, strong wage growth, and high savings across all income groups.
Incoming data for airlines, hotels, restaurants, movie theatre visits, and Broadway shows continue to be strong, and consumer services are not slowing down. And with retail sales mainly measuring goods consumption, the bottom line is that even consumer spending on goods continues to do well.
The no landing scenario continues, and the risks are significant that inflation will stay sticky around 5%, well above the Fed’s 2% inflation target.
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There are more and more signs of the market pricing the no landing scenario where the economy remains strong, and inflation remains sticky and persistent.
Not only are short rates increasing, but one-year breakeven inflation expectations are rising and approaching 3%, driven higher by the strong January employment report and yesterday’s CPI report.
In other words, the market is saying that inflation will be significantly higher in a year’s time than the Fed’s 2% inflation target. Put differently, instead of expecting a recession and lower inflation, short-term inflation expectations are rising and becoming unanchored.
In response to this, the Fed will have to be more hawkish to ensure that inflation expectations do not drift too far away from the FOMC’s 2% inflation target.
The bottom line is that high inflation and associated Fed hawkishness continue to be a downside risk to credit markets and equity markets.
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Fed measures of financial conditions show that Fed hikes since March 2022 have been offset by a rising S&P500, tighter IG spreads, and tighter HY spreads, and overall financial conditions are now as easy as they were before the Fed started raising interest rates, see charts below.
With inflation still in the 4% to 6% range, the risks are rising that easy financial conditions will boost consumer spending, capex spending, and ultimately inflation. In other words, it looks like more Fed hikes are needed to get inflation all the way back to the Fed’s 2% inflation target.
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Weekly data for global air traffic is at the highest level in five years, see chart below.
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BoJ purchases of JGBs to keep yields low are now bigger than Fed QT, and the result is that central banks are once again adding liquidity to global financial markets, which was likely contributing to the rally in equities and credit in January, see chart below. With YCC still in place in Japan, QE will continue to support global financial markets.
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The charts below show that homebuilder confidence is starting to improve, traffic of prospective homebuyers has bottomed, and the number of homeowners going into foreclosure has peaked.
Consumer sentiment has bottomed, CEO confidence has bottomed, and car buying confidence is turning more positive.
The Fed’s own measure of the true Fed funds rate has peaked, and, perhaps most importantly, inflation expectations are rising again.
Combined with strong nonfarm payrolls, very low jobless claims, and the lowest unemployment rate in more than 50 years, the bottom line is that the US economy is starting to reaccelerate.
This is a problem for the Fed with inflation at 6.5%. The risks are rising that inflation will be sticky at levels well above the Fed’s 2% inflation target.
In short, the Fed will be raising rates more than the market is currently pricing and keeping rates higher for longer than the market is currently pricing.
Our daily and weekly indicators for the US economy are available here.
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The most important feature of the no landing scenario is that inflation continues to be a problem, and the evidence is accumulating that inflation will indeed remain more persistent for the following ten reasons:
1) Fed measures of inflation persistence have stopped declining, and are moving sideways at levels around 4% to 6%, see the first chart below.
2) The housing market is starting to bottom and we are entering the spring selling season, and this will boost the shelter component of the CPI, see the second and third chart below.
3) The labor market is not showing any signs of slowing down, nonfarm payrolls is strong, the work week is increasing, the participation rate is rising, jobless claims are very low, job openings are near all-time highs, and the unemployment rate is at the lowest level in more than 50 years.
4) Used car prices have bottomed and are starting to move higher.
5) With a strong labor market and auto demand coming back, motor vehicle insurance inflation will stay strong.
6) Revenge travel continues to drive airline ticket prices higher, and travel demand remains very strong, see also here.
7) China reopening will boost prices of energy, food, iron, steel, and copper over the coming quarters, putting upward pressure on US inflation.
8) We will continue to see strong inflation in food and food away from home driven by strong restaurant demand, high wage inflation, and higher commodity prices.
9) There are capacity issues in the food and energy sectors, which will put upward pressure on inflation.
10) Financial conditions are easier than when the Fed began to raise rates, and capital markets are starting to reopen, boosting consumer spending, hiring, and ultimately inflation.
The bottom line is that the risks are rising that inflation will be sticky at the 4% to 6% level and may even reaccelerate over the coming months.
The next data point is the CPI release next Tuesday, where the consensus expects January core inflation to come in at 5.5%, down from 5.7% in December. The Cleveland Fed expects core inflation to come in at 5.6%, see also here. All these numbers are significantly above the Fed’s 2% inflation target, and the slow speed with which they are moving down toward the Fed’s 2% inflation target also points to inflation being sticky at higher levels.
If inflation stays high, it will bring back the trading environment we had in 2022 because equity and credit markets will conclude that the Fed has not succeeded yet with getting inflation down to 2%, and rates therefore need to go higher to generate more demand destruction.
In short, it is too early for the Fed to declare victory over inflation, and markets should be paying attention.
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Central banks buy gold to diversify their reserves, for example when some currencies in their portfolios have appreciated significantly, and investors buy gold when uncertainty is high to protect themselves against falling asset prices, high inflation, or geopolitical risks, see charts below.
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Investors have been underperforming their benchmarks because they entered 2023 underweight equities, expecting a slowdown that still hasn’t happened, see chart below.
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Subprime credit quality is starting to deteriorate, but the big picture is that wage growth is high, and job growth is strong, particularly in service sector jobs in leisure and hospitality. Combined with a high level of savings in the household sector, this continues to support consumer spending, see charts below. These strong tailwinds to consumer spending increase the risk that inflation will become more persistent. Expect Fed Chair Powell’s speech today at noon to be very hawkish.
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