• The CPI report surprised to the upside again. The headline CPI index re-accelerated to hit a multi-decade high. While goods inflation is easing (due to bloated inventories), food, energy, and core services CPI sped up last month.
  • Food prices continue to surge.
  • Housing-related inflation poses a key upside risk for the core CPI.

 

 

  • Rent CPI is yet to peak.

 

 

  • Durable goods are in deflation as retailers try to move inventory.
  • The Fed is now expected to take rates well above 3.5%, with most of the hikes coming this year.
  • Declining mobility in the US:

 

 

  • US office lease transactions:

 

 

  • The Treasury curve inverted as short-term yields continued to soar on Monday.
  • Last month’s retail sales surprised to the downside.
  • Car sales declined by 3.5%.
  • The Atlanta Fed’s GDPNow model forecast for Q2 growth dropped to zero in response to the weak retail sales report.

 

 

  • The first regional manufacturing report of the month (from the NY Fed) showed business activity staying soft.
  • But there are no signs yet of price pressures easing.
  • The recent US dollar strength helped to slow import price inflation in May.
  • The 30yr mortgage rate is now firmly above 6%

 

 

  • And housing affordability is near the lowest level in 15 years.
  • The U. Michigan buying conditions for homes continue to hit new lows.

 

 

  • Piper Sandler expects housing prices to decline next year.
  • Homebuilder sentiment continues to deteriorate.

 

 

  • The Philly Fed’s manufacturing index showed a similar trend to the NY Fed’s report.
    • The headline index slumped.
  • Demand is rapidly shrinking. The index of expected new orders dipped below the worst levels of the financial crisis.
  • Supply chain issues are melting away with falling demand.
  • Unfilled orders:

 

 

  • But cost pressures persist. Upstream suppliers haven’t gotten the memo yet – the party is ending.
  • Manufacturing activity at the national level is probably in contraction mode.
  • According to Wells Fargo, the US will enter a recession in Q2 of next year.
  • It’s only a matter of time before unemployment applications start picking up, as labor demand slows.
  • Wells Fargo sees the unemployment rate hitting 5% by the end of next year.
  • New home inventories point to housing price declines ahead.
  • Home equity withdrawals accelerated last year.

 

The Fed

 

The Fed delivered its first 75 bps rate hike in decades (as markets expected). The original plan was to raise rates by 50 bps, but the situation changed after the May CPI report on Friday.

The FOMC removed this sentence from its statement.

With appropriate firming in the stance of monetary policy, the committee expects inflation to return to its 2% objective, and for the labor market to remain strong.

Fighting inflation has become a much less certain enterprise, and it may require a more severe blow to the labor market to achieve this goal.

The FOMC downgraded its GDP projections and boosted the forecasts for unemployment. The collateral damage from this inflation battle is now expected to be more severe, narrowing the path to a “soft landing.”

Another 75 bps rate hike in July is still very likely.

Contrary to a what had been a growing “weaker demand” narrative, the May Consumer Price Index showed continued high inflation across the board. This raised expectations for stronger Federal Reserve action, which is why stock prices plunged Friday and again today. Gavekal’s Tan Kai Xian uses oil and lumber prices to explain why the Fed is unlikely to turn more dovish.

  • The widening gap between headline CPI and core CPI suggest the Fed will have to keep tightening even if demand weakens.
  • Years focused on core inflation helped set up the current problem, so the Fed now wants to see policy success in the “here and now” headline rate.
  • High oil prices drive headline inflation, and they stem from underinvestment in productive capacity that is not easily fixed.
  • Lumber prices are falling as higher mortgage rates reduce housing affordability. This will help core CPI but not the headline rate.
  • US recessions have historically coincided with headline CPI being meaningfully higher than core CPI, as is the case now.

Some analysts think the Fed can reduce inflation with only slightly higher unemployment by pricking the stock and housing bubbles. That would require navigating a narrow path, which the Fed has little history of doing successfully. But at this point it may be the best-case outcome.

The PPI’s highest recent increase was 11.5% in March, and since then, it has now fallen for two straight months. The BLS said the largest driver for an increase in final-demand goods was the rise in energy prices. Final-demand energy prices rose 5% in May compared to 1.7% in April.

Pro traders are also baking in a probability that the Fed will also raise rates by another 0.75% at its next policy announcement on July 27, too.

That would put the benchmark federal-funds rate closer to 2.5% by late July, up from near 1% today.

That might still sound paltry compared with interest rates of nearly 20% that former Fed Chair Paul Volcker famously enacted in the early 1980s, which broke inflation and brought on recession. But we’re starting from a much lower bar.

A 1.5% rise in today’s rates would mark a 150% hike and in about two months, if Wall Street expectations hold.

When Volcker took over as Fed Chair in August 1979, the Fed’s benchmark rate was already around 11%.

He raised rates to around 17.5%, but that took seven months. Then he actually lowered rates back to 10% before hiking them again – with inflation back on the rise – to a high of 19% in 1981, a move of less than 100%.

That crushed inflation back down to levels lower than we’re actually seeing today.

But in percentage terms, with two 0.75% rate hikes in two straight months, today’s Jerome Powell Fed would actually be doing more than Volcker’s, relatively speaking.

The point is, with all the debt in today’s world and devaluation of dollars over the decades, a 0.75% rate hike means more than it did in 1980 because we’re starting from such a low level of rates to begin with. The world is used to low rates.

And we’re looking at a potential 150% increase in borrowing costs in the economy in two months, compared with less than a 100% gain over about two years in the Volcker era. I’m not sure many people are thinking of this context.

What could make the Fed pause hiking rates?

 

 

Market Data

 

  • The S&P 500 has more room to fall to align with growth in fundamentals.

 

 

 

  • Here are the forward P/E ratios for the Nasdaq 100 …

 

 

  • … and the Russell 2000 (2 charts).

 

 

 

  • The S&P 500 dividend yield remains well below the pre-COVID range, even as Treasury yields surge.
  • The U Michigan survey tells us that US consumers are increasingly bearish, but their equity holdings remain elevated.

 

 

  • The inflation swaps market says that the CPI will peak above 9% in September.

 

 

  • The US CPI relative to the rest of the world:

 

Quote of the Week

 

“The greatest barrier to success is the fear of failure.” – Sven Goran Eriksson

 

Picture of the Week

 

 

 

All Content Is The Opinion of Brian J. Decker