Authored by Mark Orsley, head of macro strategy at PrismFP
Another undoubtedly firm inflation report as the tariff effect works its way through the pipeline. This means one thing; the stagflation narrative only strengthened today as the US economy slows in the face of supply side inflation.
Want to see what stagflation looks like?
6m Avg. NFP = green
Non-Manufacturing PMI = black
Leading Index (YoY) = blue
CPI ex-food and energy = pink
In theory this puts the Fed in a quandary. In reality, you should recognize that:
1) The data today implies Core PCE (the Fed’s inflation metric which they derive policy from) at somewhere in the 1.60% to 1.65% range. Firmer than where we were in 2Q, but still below the Fed’s mandate. Therefore, today’s data does not hold the Fed back from easing.
2) The new core of the Fed has a completely new mindset when it comes to inflation where they intend to “make up” for the time core inflation remained below 2% by letting inflation run hot. For example:
Williams: “my view is any way that keeps the average inflation rate at 2%”
Evans: “ought to communicate comfort with 2.5% core inflation”
Brainard: “we make some pre-commitments to making up so that inflation gets to 2% on average over time in a more sustained basis”
So the Fed will not pivot policy by any means with their preferred measure of core inflation not only below their mandate on a one-off basis, but nowhere near their new Average Inflation Targeting mindset.
3) At this stage of the cycle (very late with some recession signals), is supply side inflation positive for the economy? It could actually add to the malaise especially with wages now off the highs as seen in AHE, ECI, and even the latest real AHE which is down to 1.3% from a high of 1.9% earlier this year.
In theory, stagflation should be positive for duration (Green Eurodollars are probably the sweet spot) and the steepener. However, Powell delivered the pain for the steepener in the July FOMC press conference when he referred to the July 25bp cut as a “mid-cycle adjustment.” As I stated last week, that is simply intellectually dishonest.
To reproduce the graphic I showed last week in case you missed it, there is absolutely no data point that implies the US economy is mid-cycle. The green stars indicate where those data points are in the cycle. As you can see the US is late, late cycle at risk of entering recession (please see Aug 5th note for supporting charts on each data point).
The issue for all of us who have been advocates of curve steepeners is that Powell has not turned dovish enough. Meaning he should be talking late-cycle not mid-cycle and we know this because the 3m10y spread has inverted an additional -30bps since the July meeting. That wreaks of policy error and signals that the Fed is not moving fast enough to avert recession.
Powell needs drop his “mid-cycle” rhetoric and with nothing on the speaking schedule for the next week or so that means the most likely time to tidy up the message will be Jackson Hole Symposium which starts August 22nd. With every basis point of curve inversion, the probabilities of more dovish language increases.
And not until that “mid-cycle” nonsense gets dropped will rate curves re-steepen. Therefore, the market is looking at another week and a half of pain in what was the most popular macro trade of 2019; curve steepeners.
That means, while it is tempting to think about fading the curve flattening here, you likely have time and likely see flatter levels. Jackson Hole (assuming Powell speaks) is the one catalyst, besides the September FOMC meeting, where you could see a steepening reversal.
When we spoke last week, we discussed the increasing geopolitical tensions which has only worsened:
China vs. Hong Kong – much worse as I am sure you have seen
China vs. US – deteriorating further and don’t believe the hype of the Dec 15th tariff delay which is only to ease the burden on US importers during the holiday season. It is not an olive branch in any way.
Japan vs. South Korea – worse as SK chip exports have worsened this month
US vs. Iran
India vs. Pakistan
Italy budget concerns
Hard Brexit risks
And we can add a few new participants into our “paper cut” list:
Argentina – election shocker that is blowing out yields
South Africa – market sleeping on this one – Eskom “woes”, Unemployment hitting 29%, and risk of a credit downgrade to junk
European Banks – back at EU crisis lows
Japanese Banks – approaching its all-time lows
To put all this into perspective, we can simply leave all these geopolitical “paper cuts” as problematic events at a time the global economy has very little margin for error.
Stagflation at the end of a cycle with a new Fed that wants to average 2% core inflation at a time of increasing international risks will keep the Fed in easing mode. Don’t let a tweet or a headline print distract you from the macro landscape.
The steepener will likely feel the pain until Powell sharpens up Fed’s message that this is a not just a mid-cycle adjustment. The earliest catalyst will be Jackson Hole (assuming he ends up speaking).