Probably the most common error committed by financial market participants is represented by a behaviour called extrapolation. Extrapolation often occurs in the process of predicting the unknown. Forecasts are based on observations over time on the character and nature of an economic figure, which are then projected and extrapolated into the future. The narrative that inflation will continue to print uncomfortably high (i.e., well above 4%) gains ground. However, mean reversion lurks around the corner. Reversion towards normality over the next 12 to 36 months merits a higher probability than expecting another leap higher from today’s inflation index prints. I’ll go across observations, market expectations and implied volatility readings in order to offer an ensemble of data points that objectivise decision making when inflation is at generation-high levels. Extrapolation being extremely subjective. A potential 8.4% US CPI print on Tuesday April 12 might represent the peak.
OBSERVATIONS
Inflation numbers consist of transport, food, energy, housing – furnishing – utilities, recreation – culture -restaurants – hotels and other residual components. In transport, we observe that the World Container Index Shanghai to Los Angeles Container Freight Benchmark Rate per 40-foot box made a high over September 2021 at USD 12.424. This measure closed at USD 8824 last Friday. The Baltic Exchange Dry index made a high over October 2021 at 5650 but closed at 2055 last week. US CPI Urban Consumers Used Cars & Trucks NSA YOY% sat at +41.2% over February. The March reading is expected to see a steep drop when US CPI figures are released next Tuesday April 12. In energy, we take a brief look at oil (US West Texas Intermediate) and gas (gas for physical delivery at the Dutch Title Transfer Facility or Dutch TTF gas spot price). The current front WTI May contract closed at USD 98.26. This contract jumped from USD 91 on February 24, making a high on March 8 at USD 123.7. Producers’ hedging intensity is starting to trump speculator bullish calls. Same goes for gas, as the Dutch TTF spot price closed at EUR 107.50 per Megawatt/Hour. The December 2021 high of EUR 173 was bypassed following the Russian invasion of Ukraine, printing a high of EUR 212. Longer-term average ranged between EUR 15 and EUR 20. Clearly, the risks to gas supply are high. A temporary truce or genuine negotiations between Russia and Ukraine still seem distant. However the broad-based military attacks by Russia have shifted towards East and South-East Ukraine. The likelihood that the high intensity moment of the conflict lies behind us increased over the past week. An outcome to this tragedy should take a turn for the better before the summer. Expecting new surges of oil and gas pricing from current levels requires a deterioration of the war beyond the Ukrainian borders.
The National Association of Home Builders Market (diffusion) Index printed at 79 for March, the lowest reading since September 2021. Still, a reading of this builder sentiment index above 50 points to optimism. Notwithstanding, the future single-family sales gauge fell from 80 to 70, the lowest observation since June 2020. The stellar rise in the 30-year fixed, home mortgage rate from 3.25% end of 2021 to 5.06% today speaks volumes. Tightening of financial conditions for main street is already a reality. Goldman Sachs points to still loose Wall Street financial conditions. Cynically, one can say that both statements are correct…
Indeed, consensus is growing that goods inflation is dropping. The risk is present that services inflation might take over. We observe that the US CPI Urban Consumers Services Less Energy Services YoY % change plotted at +4.4%. A 30-year high services inflation level, but a far cry from the 7.9% latest overall US CPI print. The headline inflation prints of around 8% in the US and Europe have been driven by goods inflation. The US, nominal, average hourly earnings rose at a 5.6% YoY pace as released on April 1 alongside a 3.6% unemployment number.
EXPECTATIONS
The ZEW US growth expectations crashed towards -26.1 over March, nearing a March 2020 historic low print at -48. The ZEW Eurozone growth expectations sit at -38.7, even closer to a low of -48 seen at the start of the pandemic. These conditions will start to have an impact on the hiring intensity of corporates. Salary pricing power should level off…the (US) quits rate peak alongside a peaking inflation rate.
The story goes that US inflation swap markets are worried that inflation unanchors from the FED 2% longer term target. With 5Y5Y forward inflation swap changing hands at 2.73%, this inflation gauge has made a high mark over the past 8 years. Yet again, between 2003 and 2014, this inflation measure averaged 2.90% whilst average US CPI printed at 2.3%. Over that episode, we witnessed actual headline US CPI coming in at a discount versus market expectations. I cannot remember a narrative over that era that US CPI had become unanchored with 5Y5Y inflation swaps just below 3%. If anything, the market might flip towards a 2003-2014 setting: US inflation will average nicely above the 2.00% level and with market-based inflation expectations printing (well) above as geopolitical and tenuous supply risks require an extra premium.
Within the Eurozone, longer-term inflation expectations, through the EUR 5Y5Y inflation swap forwards, have settled nicely at 2.33%. The preferred range the ECB abides to sits between 2.00% and 2.50%. Mandate achieved!
The FED and the ECB will react firmly and walk a policy rate tightening path geared towards cementing current inflation expectations. The FED will hike 50bp in early May and mid-June. The ECB will prepare markets for a September lift-off.
IMPLIED VOLATILITY
Implied volatility across financial instruments measures the amount of uncertainty attached to a certain distribution of outcomes over a set period of time. Implied volatility across the food and energy commodity complex has reached extreme levels. The above observations, predicting improved demand supply conditions, warn participants that downside risks should not be underestimated. Implied volatility across rates has settled at levels that were prevalent before the 2008-2009 financial crisis.
Forward markets price US terminal policy rates between April 2023 and April 2024 at around 3.00%. However, the option on that swap, starting within a year for 1-year term, prices an implied volatility of 145bp around the 3.00% predicted mean. That effectively translates into outcomes that are distributed for a high FED fund rate at 4.5% by April 2024 versus a low 1.5% outcome by then. Implied volatility conditions that are common for highly speculative oil, metal or grain markets have reached rate markets. In a way, equity markets have become less sensitive to monetary policy decisions. Wait a minute, that might be exactly the purpose of monetary authorities.
