The Daily Spark

Markets think the inflation problem has been solved. But that is the wrong conclusion. 

The chart below shows that supercore inflation, which is the Fed’s preferred measure of inflation because it excludes housing, is sticky at 4.5% and not showing any signs of moving down to the Fed’s 2% inflation target. In fact, supercore inflation increased in July because of strong inflation in financial services, transportation, food services, amusement parks, and sports.

The bottom line is that inflation is still a problem, and equity markets, credit markets, and rates markets are underestimating how much additional slowing is still needed in the service sector to get inflation under control.

Since the Fed started raising rates in March 2022, deposits in the banking sector have declined by $862 billion, see the first chart.

Over the same period, almost the same amount, $896 billion, has gone into money market accounts, see the second chart.

Our banking sector chart book is available here. It shows that credit growth continues to slow, and bank lending conditions continue to tighten, see the third, fourth, and fifth charts.

Since the ECB started raising rates in July 2022, corporate bankruptcies have trended higher, driven by transportation and storage; accommodation and food services; and education, health, and social activities—see chart below.

With the ECB keeping rates high well into 2024, we should expect these trends to continue.

When interest rates increase, the household sector has to pay more for debt.

But when interest rates go up, households also receive higher cash flow on fixed-income assets.

Dividing households’ interest payments with households’ interest income shows that debt servicing costs as a share of interest income are at the highest level since 1959, see chart below.

In other words, both debt servicing costs and interest payments have increased as the Fed has raised interest rates. But debt servicing costs have just increased more.

One way to better understand the impact of BoJ YCC exit on Japanese demand for US Treasuries is to look at how much of the recent increase in US long-term interest rates has happened during Tokyo trading hours.

The chart below shows that since the BoJ YCC exit surprise in late July, the move higher in 10s has occurred almost entirely during New York trading hours.

This suggests that US rates are not driven higher by Japanese investors during Tokyo trading hours. And hence, BoJ YCC exit doesn’t seem to be the reason long rates have increased over the past month.

Instead, likely drivers of US rates over the past month are the US sovereign downgrade, fewer dollars for China to recycle in a falling exports environment, Fed QT, the significant budget deficit, the large stock of T-bills, and the Treasury’s intention to increase coupon auction sizes.

Despite the unemployment rate being at the lowest level in 50 years, credit card delinquency rates at small banks are at the highest level on record, see chart below. Imagine where these lines will be once the labor market finally begins to soften.

The map below shows the number of new business applications per 1,000 residents, and there are a lot of entrepreneurs in the Southeast, in particular in Florida.

Since the Fed started hiking in March 2022, default rates have been moving higher, and every day there are companies that cannot get a new loan or refinance an existing loan.

This is how monetary policy works. A higher cost of capital makes it harder for firms to get financing.

With the strong uptrend in defaults over the past six months, and the Fed keeping interest rates at elevated levels, the HY default rate could reach 6% by the end of 2023, see chart below.

The bottom line is that a default cycle has started, and markets are not paying attention.

The IMD every year ranks the competitiveness of countries by comparing indicators for Infrastructure, Business Efficiency, Government Efficiency, and Economic Performance, see table below.

Over the past decade, Germany has moved from being the ninth most competitive economy in the world to currently number 22. The current rankings for Germany across the four categories are: Infrastructure (14), Business Efficiency (29), Government Efficiency (27), and Economic Performance (12).

When interest rates increase, holders of fixed income get a higher cash flow. The problem is that the Fed and foreigners own 50% of Treasuries outstanding, and foreigners own 28% of IG and HY credit outstanding, so a lot of the additional cash flow created by higher US yields is not boosting US GDP growth.

The bottom line is that higher interest rates are a net negative for the US economy, see also the third chart, which shows the effects on US GDP as a result of raising the Fed funds rate 5%-points using a model similar to the Fed’s FRB/US model of the US economy.