The April consumer price index and ongoing stock market turmoil captured much of investors' attention over the past week. They may be looking in the wrong places, at least when it comes to predicting the path of Federal Reserve policy.
One of the biggest questions investors have lately is whether the so-called Fed put -- the idea that the central bank will backstop financial markets and rescue investors from serious downturns -- is still alive. Many prognosticators say it is dead, because the Fed is so far behind the inflation curve that it has no choice but to tighten even if stocks crumble. The S&P 500 is down about 14% from its January 2022 all-time high, a loss that is approaching the roughly 20% decline that prompted the Fed in January 2019 to stop shrinking its balance sheet. This time, quantitative tightening, or QT, hasn't even started, and central bankers sound increasingly hawkish, despite the carnage.
The Fed put probably still exists, if at a much lower strike price than investors have come to expect. The idea is that if stock prices fall far enough, the hit to household wealth would spill over into the broader economy. But while stocks matter, investors may be looking at the wrong market. It is pain in the credit market that will ultimately make the Fed relent, says Joe LaVorgna, chief economist for the Americas at Natixis, pointing in particular to the junkiest of junk bonds. That is where problems tend to originate, threatening a melt-up in the bond market that is akin to collapsing dominoes.
Relative to U.S. Treasuries, the yield on CCC-rated debt is widening quickly and substantially. That spread grew to about 10% this past week, the highest level since late 2020 and around levels where the Fed has previously eased monetary policy to counter slowing economic growth. LaVorgna pegs the strike price of the Fed put at a yield spread of 1,500 basis points, or 15%, between CCC-rated debt and the five-year U.S. Treasury note.
"You can get there pretty quickly," he says, adding that the catalyst for such a move may come as early as next month, when the market has to absorb about $50 billion in extra Treasury and mortgage-backed securities supply as QT begins. "We know it is coming," LaVorgna says. "But when it actually comes, we need buyers other than the Fed, and that will suck liquidity out. No one knows how to price for this."
The idea that the Fed could so quickly pivot flies in the face of recent Fedspeak. Consider Fed Chairman Jerome Powell's comments on Thursday that the one thing the Fed can't do is fail to restore price stability, even if it means economic pain. It also belies the latest inflation data. But investors interested in the weeds might find reason to wonder if the Fed already has a cover in the making that will allow it to more quickly shift its focus to weakening growth data.
First, the latest inflation data. The April CPI report wasn't good. Ahead of it, expectations ran high that the data would confirm what economists and strategists across Wall Street thought they already knew. But while headline CPI slowed a touch in April to an 8.3% pace from a year earlier, the report lacked evidence that inflation has really peaked, says Jefferies chief economist Aneta Markowska. Consider that the so-called base effect artificially pushed the year-over-year metric lower as a particularly high reading from a year ago fell out of the calculation, as well as the fact that the April decline in energy prices has reversed. Prices at the pump hit a record during the week, while diesel prices extended a streak of daily record highs.
All of that is before getting to the guts of the CPI report. Service-sector inflation is surging, undermining the conventional wisdom that inflation is mainly about supply-side issues that the Fed can't affect. Services inflation is rising beyond shelter prices, which represent a third of total CPI and won't slow soon, as rents lag behind still-rising home prices by about a year. What is more, CPI excluding food and energy doubled from a month earlier to rise a faster-than-expected 0.6% in April. Policy makers favor core measures, and Powell has suggested that month-over-month readings are more important than year-over-year levels as the Fed monitors price changes -- meaning the worst number in the April CPI report was the most important one.
The April producer price index, released a day after the CPI, didn't improve the picture. Wholesale prices rose 11% from a year earlier, a fifth consecutive double-digit increase and a sign that companies will continue to push higher prices through to consumers or eat them at their margins' expense.
Here is where there is some hidden good news. Economists use the details of the CPI and PPI reports to predict the Fed's favored inflation metric, the core personal-consumption expenditures deflator. Put the latest inflation reports together and the core PCE probably rose at a much more benign pace last month (it is due out on May 27). Citi economist Veronica Clark points particularly to legislated cuts in Medicare payments to medical-services providers, which weighed on medical-services prices. She sees the core PCE rising 0.3% in April from March, matching the prior two gains, and 4.8% from a year earlier, down from a 5.2% pace a month earlier. Economists at Goldman Sachs estimate smaller, 0.2% and 4.7% monthly and annual rates of increase. The former would be the smallest gain since late 2020; the latter would mark the slowest pace this year.
There are problems focusing on the core PCE. It tends to run about a half-percentage point below the CPI, in part because of differences in how medical and housing costs are treated, and inflation already feels worse to many consumers and businesses than even the CPI shows. But for the purposes of predicting the path of monetary policy, it is the metric that counts most, and it is slowing faster than other inflation figures.
Consumers and businesses don't yet feel like price inflation has peaked. But a faster slowdown in the core PCE deflator alongside a brewing storm in the high-yield credit market mean that it's possible that Fed hawkishness has.
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