ACTV - Markets Have Muted Reaction To Latest U.S. CPI Data. Will The Fed?

2023-09-16 05:36:00 ET

Summary

• Why market reaction to U.S. CPI has been muted.
• Will the Fed stay the course?
• The outlook for fixed income as inflation shows signs of cooling.

The latest U.S. Price Index showed prices rising the most in more than a year, mainly due to higher gasoline prices. Scott Colbourne, Managing Director & Head of Active Fixed Income at TD Asset Management, discusses the market reaction and implications for monetary policy.

Greg Bonnell : US inflation pushed higher in August on the back of higher gasoline prices. This, of course, coming just one week ahead of that next rate decision from the US Federal Reserve. Joining us now to discuss it all, Scott Colbourne, Managing Director and Head of Active Fixed Income at TD Asset Management. Great to have you back on the show, Scott.

Scott Colbourne: Good to be here.

Greg Bonnell : So it's interesting, the market reaction, whether it's the bonds, the side, the equity side, the currency trade. We did get that tick higher in inflation. But at this moment, it seems that the market's taking it in stride. What did you see in the numbers? And how do you think the market's interpreting them?

Scott Colbourne: Yeah, there was a mild surprise on the core side, right? So a little upside surprise there. But at the end of the day, as you note, the market reaction has been pretty benign. And I think from the point of view of next week's Fed meeting, they basically have telegraphed that they're on hold into next week's meeting.

So it's not really much of a surprise to the market. I would say the broad trends of inflation are consistently moving in the right direction. When you look at 3-month annualized, core inflation is down about 2.4%, six months a little higher at 3.7%.

So I think when you think about central bankers and what they've said here in terms of policy, we've gone a long way on inflation. We've gone a long way in monetary policy.

The next sort of the last mile, if you will, between where inflation is right now and hopefully by mid next year, end of next year, it's a longer road to travel. But the direction is in place. And so from a market surprise point of view, I don't think there was much in today's data. Small interpretations of this way and that way, but the broad trend is in place. And it's consistent with policymakers are saying.

Greg Bonnell : And of course, I mean, the central bankers have never said it would be one line from 8% or 9% inflation straight down to 2%. There'd be a bumpy road. The Bank of Canada, when we last heard from them, they warned about the same thing. We know it doesn't take an economist or a big thinker to say, hey, I'm paying more when I fill up my car all the time. This seems to be sort of what's pushing headline further higher and could push it even higher in Canada and the States in months to come.

Scott Colbourne: Yeah, you've got some risks. But I think the central banks can be patient here, right? You're going to let some of the noise and some of the choppiness, whether it's energy prices, play out. They're going to be on hold here and watch the labor developments on wage both in Canada and the United States. Obviously, we've got potential strikes in the US coming up.

So there's a lot for them to be patient and let the data play out here. There's no need to accelerate the aggressive policy because we've had a lot of that. They've frontloaded it. And it's been one of the rapid tightening cycles. So let's let the lags play out, the monetary policy lags play out here, and see how things evolve over the next three to six months.

Greg Bonnell : Even if they are on pause or on hold and stay there, they have warned us and repeatedly that they're going to stay at an elevated level for a while. Is that the -- I mean, we don't know their minds. Is that the long-term plan? Or is that simply what you need to tell the market to keep achieving this downward path for inflation?

Scott Colbourne: There's so much uncertainty right now. Everybody's in this data-dependent mode, right? Broadly speaking, when you look at the markets, the fixed-income markets, there are three broad drivers right now, growth, inflation, and liquidity. The inflation story is on the right path.

And if you look at today's market reaction, the markets are really not reacting to inflation anymore. The narrative has been put into the market. The central bankers have told us they're patient. They're going to keep things here for a while until see further improvement on inflation. They're really focused on the growth, the labor, the wages, and see how that develops.

And obviously, we've seen a lot of surprise on that side this summer, right? Between mid-July and August, we had a backup in rates of 50 basis points. Personally, I think that responded to a growth shock in the US. And obviously, there's a lot more supply in the market, both corporate and government.

So I think the central bankers are content to say, we're going to watch particularly on the labor development, the growth, the employment, and how growth plays out over the next little while. And we'll keep things here on hold for as long as possible. They do pencil in-- the Fed has penciled in a cut next year, right?

So we'll see how things evolve. We've got another summary of economic projections next week that will be released to see where they think things evolve. They've also said they're going to have another hike in the markets or at least the option to hike into the end of the year.

So very data dependent. I think Governor Powell said, look, we're navigating by the stars, referring to r-star, under a cloudy sky. So I think that really speaks volumes to how we're navigating here. Very data dependent. We think the trend is in place. It's a little stickier than we expected.

Greg Bonnell : When it comes to what they've been trying to do all along and cool the economy, they said-- they warned us at the outset there's going to be some pain here. And like you said, the labor market's been resilient. The consumer might slow down a little bit, but still spending. And it seems now that when you put all that together, people say, well, maybe we get the soft landing. Maybe we get no landing. Maybe you can do all this and get inflation under control, and we're going to walk away without too many wounds to bandage. Can that happen?

Scott Colbourne: I'm always a bit of a skeptic. I've been doing this for a while. It's different this time that there's not been many soft landings. It's a really hard objective. I mean, if you think of what we've gone through, we went through a pandemic shock. And the monetary and fiscal policy response has been off the charts.

And to think that monetary policy is going to land this supertanker on that soft landing given the massive stimulus that we've had, I'm a little bit of a skeptic. I don't believe that we're going to get there. I'm still in the mild recession camp. But prove me wrong. It's a really tough thing to navigate.

So if monetary policy is on hold, I think we'll see that the lags play out in 2024. I'm in mild case because I think both corporates and households went into the pandemic in much better shape than they have been in the past. So it's more of a mild recession. And the monetary policy will bite. And fiscal policy will ultimately stop being a tailwind.

Greg Bonnell : Take all that. We think about what it means for the fixed-income market. Obviously, we're seeing yield we have not seen in a long time. But some people thought perhaps we would have been cutting by now, and that would have been something else for bond prices. How do you see it all playing out?

Scott Colbourne: I think that, ultimately, we'll see one, two cuts next year at some point in the US. I think that's my base case over the scenario. At minimum, what you're going to see is inflation continuing to move down. The markets expect inflation to be 2.5%, 2.6% headline inflation June to September of next year.

If the Fed doesn't recalibrate interest rates, what you're going to have is real rates continue to move up. And that is a tightening continuing to tighten into a downward trajectory in inflation.

So I think that the Fed can recalibrate modestly so still behave with higher for longer and still be disciplined here. But I think net-net, it's a very attractive level to be adding some fixed income to your portfolio. Absolute yields, as you note, are very attractive historically. So I think it's still a positive.

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