QQD - U.S. Inflation Growth Eases But Will That Slow The Fed Down?
- Latest CPI might help sentiment, but inflation is still a problem.
- Why shelter inflation is creating a more complicated fight for the Fed.
- Softer CPI could mean the Fed avoids another jumbo rate hike, but rates are still going up.
U.S. inflation data for July came in lower than expected, potentially easing pressure on the Fed's battle against rising prices. Greg Bonnell speaks with Hafiz Noordin, Portfolio Manager for Active Fixed Income at TD Asset Management, about the outlook for interest rates.
Transcript
Greg Bonnell: Latest US inflation report coming in lighter than expected. The price of gasoline moved lower in the month of July. But of course, the big question for investors is whether this will ease the pressure on the Fed to continue with those big, super-sized rate hikes that we've been seeing lately. Joining us now for his take, Hafiz Noordin, portfolio manager for global active fixed income at TD Asset Management. Great to have you back on the program. Let's jump right in. Of course, this was the big number everyone was waiting for. We're definitely seeing some very clear reaction in the equity and bond markets based off of this.
Hafiz Noordin: That's right. Everybody's celebrating today because I think it was almost a year since the US CPI did not surprise to the upside above consensus expectations. So the market got really used to these volatile days leading up to US CPI, where consensus would expect something, and CPI would come in higher. This time around, economists were expecting about 8.7% for US CPI year over year. In July, it came in at 8.5%, so a little bit lower, still a very high number, but also on core CPI, expecting 6.1 -- it came in at 5.9. So I think this definitely helps for sentiment, but I don't think the inflation story is raising the white flag just yet.
Greg Bonnell: The devil's always in the details on this. So we get -- let's get below that number. You touched on core there. Ultimately, what will it take to bring inflation down in a way that would make the Fed happy over the next several months? We had 0% month over month. There's some sticky elements in that core number, though?
Hafiz Noordin: Absolutely. And, you know, I think the stickiest part that we have to watch is shelter prices. And it came down a little bit on a month per month basis. It was kind of at a 0.6% month over month. And now, it came in at 0.5. But the trend is very clear in shelter prices, and that's the one that drives a very large part of the CPI basket and is also very linked to the cycle. As wages are going up, which we know that's happening, then shelter prices go up too. So that part isn't over yet. The trend is still there. Shelter prices are about 6% year over year in terms of its run rate. And so that's the part where the Fed really has its work cut out. The easy stuff that will start to normalize are things like airfares and used car prices, things that have been really outsized drivers of inflation recently. That's what drove the sort of miss today in US CPI. And so that can continue, but the stickiness is definitely still there in terms of shelter and other core services.
Greg Bonnell: All right, so with that in mind, let's get back to the market reaction. Not only have we seen that rally in equities -- at the same time, it seems that market participants are starting to peel off their bets about another jumbo 75 basis point hike from the Fed, that this gives them, you know, a bit of freedom to say, oh, maybe it's only 50 next time. Are they reading too much into this just one month of numbers with those other considerations?
Hafiz Noordin: Yes. Well, one month of course can never make a trend. And I think, for the most part, we know what's going to happen for the rest of 2022. We know the Fed or the Bank of Canada are, in some way or another, going to get to, call it 3.5% policy rate by the end of the year. So whether that's a 75 basis point hike in September and then smaller ones later or 50 basis points in September, I think that will move around over the next month or month and a half. As it stands right now, 50 basis points is now a little bit more likely than 75. So we'll wait to see what happens. There's still going to be another job sprint. That is also -- the labor market is still very important to watch in terms of what's happening in terms of the tightness of the labor market but also the wage growth story. Wage growth is still very high. And at the end of the day, that's an important forward-looking indicator for inflation. So we'll see some volatility, but at the end of the day, we know what the Fed and Bank of Canada are going to do towards the end of the year.
Greg Bonnell: Now, once we get past the end of the year, then you have market participants, some of them at least betting that once we get to the end of the cycle -- and it's been pretty brutal and pretty swift, like a lot quicker than anyone thought, would have happened in the depths of the pandemic. But once we get past that, they're going to be in a situation where we have to start slashing again. Is that a little too optimistic if that's how someone's positioned in their portfolio?
Hafiz Noordin: Yes, it's interesting. We had this term called the Fed pivot that came up recently and was driving some of that market reaction where a lot of market participants thought that the Fed started to sound more dovish, and it would mean that the growth story was going to become more important than inflation story and lead to these rate cuts starting as early as Q1 or Q2 next year. I think it's less of a pivot and more just the Fed trying to gain some more optionality, some more flexibility in how they're going to behave because there's just such a range of outcomes for both growth and inflation over the next 6 to 12 months. So I think that's where there is some vulnerability in the market where rate cuts are getting -- are still priced in for next summer. And so that would imply that, even though inflation's going to be maybe 4% next year, the growth picture will have to deteriorate enough that the Fed will need to cut. So that's where we have to watch the data. And if the economy in the US and Canada is still proving to be fairly resilient, that's the part of the bond of the yield curve that could reprice, where instead of cuts, we kind of stay close to this restrictive policy level of 3.5% to 3.75%.
Greg Bonnell: Let's talk a little bit about the yield curve because in previous times when things weren't so volatile, we would look at an inversion of the twos and 10s and say the bond market is telling us something. They're telling us that we have a rough road ahead, that we have, perhaps, even a recession ahead. Of course, everyone's watching the inversion pretty carefully right now. Is it still that same measure, or have things become so volatile and so different coming out of the pandemic that we really can't say this equals this equals this?
Hafiz Noordin: Well, the yield curve inversion has always been an interesting one where, yes, historically it's preceded recessions, but the time lag between an inversion to when you actually get a recession can really vary quite a lot. It can be less than a year to up to three years. And it's just different every cycle. And I think what we need to do is take a step back and say, yes, the bond market is saying that there's lower growth ahead, and monetary policy will need to stay tight -- we'll need to be in more restrictive territory. That's why we have two-year rates so high. But what we have to just watch is, what's the nature of the inflation dynamics? Can we actually get closer to 2% any time soon? I think that's where there is some skepticism and probably means that two-year rates have to stay high. But whether growth can stay resilient really will define whether the 10-year rate gets meaningfully lower than the two-year rate from where it is now and starts to indicate a recession is coming. And I think it just really is going to be data-dependent. But looking globally, the UK, for instance, we are seeing more projections for recessions in some other developed economies. So we do need to watch that.
Greg Bonnell: We talked about some of the stickier elements of core inflation just a couple of minutes ago -- of course, wages can be sticky once you've got the wage. Pretty hard to take it back. Of course, we're worried about rents and shelter costs as well. Are any wild cards -- I mean, you get this, you say we get one print. You say, ooh, coming softer than expected. Maybe we've reached peak inflation. Maybe we'll start to ease from here. What wild cards could trip us up?
Hafiz Noordin: Well, I think energy costs are still one that's always going to be volatile. And it's-- we look at core inflation because it excludes food and energy. But the reality is, food and energy prices have mattered a lot for consumers, not in terms of hitting the wallets now, but also in terms of building inflation expectations. If you're seeing higher prices at the pump or in the grocery store, that will influence your psyche around what to expect in terms of prices going forward. And so right now, we're seeing relief at the pump. Food prices are still kind of chugging higher. Those are the parts of the equation that I would worry about because they could really revert back the other way, depending on what happens in terms of the Russia-Ukraine situation, how sanctions evolve. And so I think that's the part that's more of a wild card. The flip side of that is that shelter prices -- you know, I wouldn't call it a wild card. It's just kind of a known stickiness. And so we just have to keep monitoring that as well. And if we are seeing a reduction in inflation expectations right now, we still have to keep in mind that shelter really drives everything.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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U.S. Inflation Growth Eases, But Will That Slow The Fed Down?