FTDS - January Inflation Deals A Big Blow To The Bulls' Narrative

Summary

• Inflation was hot in January.
• This is putting the Fed on a path to raise rates well above 5% in 2023.
• The equity market appears to have wrong on disinflation.

To no surprise, CPI proved to be hot in January on a month-over-month basis, rising by 0.5%, in line with expectations, and by 6.4% year-over-year vs. estimates of 6.2%, and down just a bit from December 6.5%. Core inflation also was hot, rising by 0.4% month-over-month and up from last month's 0.3%, while rising by 5.6% year-over-year hotter than estimates of 5.5% and down a touch from 5.7% last month.

Even Higher For Even Longer

The latest data supports the idea that inflation will likely be sticky and not fall as quickly as the equity market believed. This will result in the Fed keeping policy tight for all of 2023. But the big risk is that the Fed's target of a 5.1% terminal rate may not be too low, and the Fed will need to push rates even higher than the projections noted at the December FOMC Meeting.

The bond market is certainly responding and pricing in an even higher for longer monetary policy. Fed Funds Futures are now trading at 5.10% for the December contract, while the August contract is now trading at 5.27% and is now the peak terminal rate.

Rates Surge

The futures contracts' rise is also driving the 2-year rate up to approximately 4.6%, breaking out of a consolidation zone of approximately 4.50%. Based on technical analysis, this could cause the 2-year rate to rise back to 4.75% in the near term.

A higher two-year rate is supported not only on a technical basis but also on a fundamental basis. The spread between the 2-year rate and the December Fed Funds futures has widened to nearly 50 basis points, one of its largest spreads in some time. These levels of the December contract should help lift the 2-year rate.

As the 2-year rates increase, the entire Treasury curve is being repriced, causing the front of the curve to move up. This could lead to the 10-Year moving closer to 4%, assuming the spread between the 10-Year and 2-year rates remains at around 80 basis points.

Volatility Reset At First

Stocks rallied despite the rising rates, at least initially. The immediate reaction in stocks may be due to a reset in implied volatility that often occurs after significant events. Although this is not readily apparent in the VIX index, it's evident in shorter-dated implied volatility, such as that of a one-week 50 delta S&P 500 options. Following the data release, implied volatility dropped, creating a reset and propelling equity indexes higher at first. However, this initial surge could be a false knee-jerk reaction.

The underlying story is the movement of rates and the relative expensiveness of stocks compared to bonds. This relationship is most noticeable on the Nasdaq, with the spread between the Nasdaq earnings yield and the 10-year TIP steadily narrowing. The spread is currently around 2.3%. The equity risk premium in the Nasdaq vs. real rates has dropped to levels not seen in more than a decade. As rates rise, stocks become increasingly expensive, putting them at risk.

The equity market appeared to be betting on disinflation leading to lower bond yields, as evidenced by the decline in the earnings yield of the Nasdaq toward the 10-year TIP rate. However, with the release of a strong jobs report and CPI figures, it is becoming increasingly likely that bond yields will not decrease but instead rise. This implies that the earnings yield of the Nasdaq will need to increase, necessitating a fall in the PE ratio, which could drag down the Nasdaq and the entire market.

Once again, the bond market seems to be correct, and equity has received a severe reality check. Based on the data, the Fed is likely to pursue a path that may result in rates well above 5% in 2023.

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