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Markets Need a Less Rosy View of Inflation News

Goodbye CPI Tuesday

“CPI Tuesday” doesn’t have the same ring as some other regular market dates, but there’s little denying that no single data release matters more these days than US consumer price inflation. Tuesday morning’s release on price rises in August will matter a lot. 

Judging by the rally in equities over the last few days, plenty now believe that the August data will show a continuing decline, and ram home that the peak is in. For a cynical but fair take on the optimism, this is what Peter Tchir of Academy Securities Inc. said ahead of the numbers:

Everyone is waiting for Tuesday’s CPI data. We will get officially told what inflation was in August. It is unlikely that it will reflect what we see and feel every day. It doesn’t tell us anything about where September will be (actually, that is not true, as some of the data will be so off, that it will have to get fixed in next month’s report, and some is just stale by its nature (housing)….

The market has concluded that both the ECB and even the Fed, despite their protestations otherwise, are both being viewed as data-dependent. I cannot see any scenario where the market doesn’t decide that CPI is heading the right direction and that October will be lower than September and so on and so forth (so many commodity futures contracts that I checked out are all lower forward than spot). That combination should allow markets to continue to enjoy the strength that they saw towards the end of last week.

There is good reason for the growing optimism on inflation — but as Tchir suggests, that optimism is nowhere near as strongly rooted in facts as many have now convinced themselves. Yes, it does look ever more as though the peak for inflation is in, and that is far preferable to a situation where inflation rates were still accelerating. But the key is how quickly price rises come down. The Fed still wants to get inflation down to its target of 2%, and that is still a long way off.

Data produced by the New York Fed on underlying inflation, looking at correlations between different CPI components, and also with some macroeconomic variables, show what looks like a plateau after reaching a historic high:

Another Fed, from San Francisco, created two baskets for products that were most affected by the Covid-19 pandemic, and those that were least sensitive to it. The Covid-sensitive measure has been declining for several months, and peaked before it was able to pull Covid-insensitive prices with it. That can only be good news for those hoping inflation will soon come down:

Moving on, the Atlanta Fed published its latest wage-tracker data last week, using census numbers to show how wages rose during August. This series is also at historic highs, but the overall level of wage growth appears to have stabilized just below 7%. Wage rises in the lowest-paid quartile, which have run ahead of the average, also remained unchanged after an impressive surge. 

A few more months like this would make central bankers more comfortable that a “wage-price spiral” had been averted. But wage settlements remain far too high for the Fed’s comfort, and persisting high levels of headline inflation will continue the pressure on them. The point is that these numbers have to come down significantly before the central bank can declare victory:

Stronger evidence that a wage-price spiral can indeed be avoided came from Monday’s publication of the New York Fed’s latest Survey of Consumer Expectations. This found expectations for inflation three years hence had dropped below levels that were typical before the pandemic, while expectations for the next year have dipped sharply from a very high level. This data should unambiguously encourage the Fed that it is succeeding in reining in angst over inflation:

So some degree of optimism over inflation is justified. But the question the equity market may be ignoring is what it would take to convince the Fed to stop hiking and even start cutting rates again. It’s hard to see how it can cut unless inflation is plainly on its way back to 2% (and nothing can prove that as yet), or economic growth starts to decline noticeably (the reverse has happened in the US as the oil shock has eased during the summer), or there is a clear-cut financial accident. There may be arguments that hiking much further would be dangerous, but the current buoyancy of the stock market ironically argues against them. 

What is troubling is the way that the stock market is ignoring one of the key indicators from the bond market — the real yield. The yield on 10-year TIPS, which offers inflation protection, is at a new high for this cycle and approaching 1%. This was the level that prompted Jerome Powell and the Fed to implement their infamous “pivot” at the end of 2018, having promised to press forward with quantitative tightening on “autopilot” and then stopping those plans and bringing a halt to rate hikes. Stock markets are behaving as though some kind of repeated pivot is a given:

The problem is that the 2018 pivot followed a sharp and ugly selloff in the stock market. That convinced the Fed that financial conditions were too tight for the market to bear. There is no such repeat this time. 

Meanwhile, speculators in the fed funds futures market now expect the Fed to peak at 4%. This is its highest for the cycle, with the latest rise happening even as the stock market was reassuring itself that inflation was beaten. This is how the implicit expected rate as of the Federal Open Market Committee meeting due in February next year has moved since last summer:

The news on inflation has been hopeful of late, and the next data download might be even better. But it looks as though the stock market is viewing it through rose-tinted glasses. 

The Golden Ratio

When the dollar strengthens, one precious asset class loses some of its luster: gold. The price of the yellow metal rose for a second session Monday as the dollar extended its retreat from two-decade highs last week. It appears to have found a floor near $1,700 an ounce this month after slumping in August on the dollar’s rally — but remains far below the $2,050 it briefly hit during the wave of risk aversion that accompanied the invasion of Ukraine six months ago.

“Gold is having a great day as inflation expectations are dropping,” Edward Moya, Oanda senior market analyst, wrote. “It seems the ECB’s latest round of hawkishness is countering all the talk from the Fed about leaning towards another significant rate rise. This is a turning point in the gold trade and if inflation continues to slow, bullion should continue to stabilize here.”

In general, demand for the yellow metal depends mainly on currency, rates and commodity moves — unless there is significant broader market volatility driven by external shocks. As gold pays no yield, it has a strong traditional relationship with real yields on bonds; when real yields are negative, as they have often been over the last decade, that makes gold more attractive, and vice versa. 

As such, 2020 was a remarkable year in terms of implied investment demand, according to Bank of America strategists led by Michael Widmer, when real yields tanked amid the pandemic and gold surged by 27%. BofA defines investment demand as including bar hoarding, physically backed exchange-traded funds, over-the-counter net-investment, and official sector purchases (mostly central banks). As the charts below show, all these categories rallied:

Still, gold offtake — contracts to buy the metal from mining companies — dropped sharply in 2021, bringing the uptrend to an abrupt halt. This is why gold quotations rose by only 1.6% for the year. In 2022, the picture has dulled, with outflows from physically backed ETFs offsetting a rebound in central bank purchases. They explain more below:

We have previously shown that a four-factor model consisting of US 10-year real rates, [dollar index spot], Brent oil prices and cross-asset volatility can explain most price movements in the yellow metal. Against recent sharp moves in USD and rates, gold has been relatively resilient. Indeed, we estimate that gold trades about 10-15% above the level fundamentals would imply at the moment. One way to justify that is by looking at inflation.

Out of the four, let’s focus on gold’s relationship with oil, another store of value that arguably provides a clearer view of the metal’s worth than any paper currency. The graph below shows that the ratio of oil and gold prices has now returned almost exactly to its level of the early 1960s, when the oil price in dollars was fixed, and the US dollar was fixed against gold under the Bretton Woods system. Many viewed the dollar as overvalued at the time, but oil’s value in gold persists. 

The Bretton Woods system dissolved between 1968 and 1973, at which point the graph below shows a steep drop. That in turn led to an equally sharp rebound during the oil embargo that followed the Yom Kippur War. In 1968, central banks stopped buying or selling gold in the open market, and in August 1971, President Richard Nixon announced the “temporary” suspension of the dollar’s convertibility into gold that continues to this day:

The ratio between gold and oil has evolved in the past half century, but seems to have a gravitational relationship with its Bretton Woods level. The global pandemic combined with the breakdown of OPEC discipline to cause 2020’s dramatic plunge, a black-swan event that left the oil/gold ratio even lower than it had been in 1973. It steadily recovered until the saber-rattling over Ukraine began to cause gyrations.  

At present, the dollar is paring its gains and that is buoying the gold price, while Brent crude is at $92.50 per barrel. Analysts see gold continuing its recovery if the dollar dips further, though that in large part hinges on the US CPI data. Thanks to the way the latest oil shock has affected Europe far worse than the US, the standard inverse relationship between the dollar and the oil price has broken down for now:

In all, BofA strategists see rising real rates as the immediate headwind to gold prices:

Granted, inflation is now moving lower, especially on the goods side, with the Fed intent to accelerating that dynamic, partially by cooling down the labor market… This suggests the US central bank has a slightly easier task than the ECB, which is hiking at the same time as Europe is going through an inflationary energy crisis supply shock. Either way, this suggests that US real rates may well move higher from here near-term, which should keep gold prices capped for now.

As the BofA chart shows, that might concern gold investors because the rise in real yields to date implies that gold could fall much further:

Can gold continue to stabilize? As ever, and you’ve heard this before, that depends on the future of US inflation.  

—Assistance by Isabelle Lee

Survival Tips

In a weird and sad coincidence, Gwyneth Powell passed away on Thursday of last week, the same day as the Queen. For British children of my generation, she had an almost regal aura as the actress who played Mrs. McClusky, the principal of “Grange Hill,” a long-running BBC soap opera set in a high school. It was brilliant. For a McClusky highlight reel, look here. It’s great TV drama and it perfectly evokes what it was like to be a pupil of a British school in the 1980s. 

Returning to the perhaps more consequential news of Elizabeth II’s passing, it’s interesting that some degree of criticism is beginning to appear. John Oliver’s take is worth watching. And the country now has to grapple with how it can possibly justify continuing to live under a hereditary monarch. It’s an embarrassing anachronism, and while it seemed to make sense while anchored by Elizabeth’s personal authority and popularity, it now looks far harder to support. Those on the left of politics, in particular, have a hard job to justify why they are not moving forward with steps to make Britain a republic. Now that Elizabeth has been replaced by her far-less popular son, what excuse does the Labour Party have for not taking on this archaic remnant of privilege?

For a remarkably clear explanation of how monarchism survives, I recommend this excellent column by Paul Waugh. He points out that Clement Attlee, the socialist prime minister who established Britain’s welfare state after the war, wrote a defense of the monarchy, which he saw as a bulwark against extremism and a focus of unity. This passage from Waugh’s column is worth reading:

Crucially for any Labour leader, Attlee pointed to something more fundamental than pragmatism. He argued that as the party for the working classes, Labour knew better than any party that those workers most felt a deep connection through the monarch to their own nationhood and history, in a way no Prime Minister could. Starmer knows that if he wants to win back his party’s lost “Red Wall” [working class constituencies in northern England that have swung to the Conservatives], he has to maintain that link too.

With no parliamentary party willing to press its cause, it’s hard for British republicanism to make headway. Maybe there is more of a case for hereditary monarchs than we thought. And for evidence of the enduring affection for the monarchy in northern England, try watching Alan Bennett’s great A Private Function, featuring Maggie Smith and Michael Palin about attempts to celebrate the Queen’s wedding amid the austerity of 1947. It involves kidnapping a pig, it’s very true, and it’s very funny.Like Bloomberg’s Points of Return? Subscribe for unlimited access to trusted, data-based journalism in 120 countries around the world and gain expert analysis from exclusive daily newsletters, The Bloomberg Open and The Bloomberg Close.

More From Other Writers at Bloomberg Opinion:

• James Stavridis: Ukraine’s Wins Make Russia War More Dangerous

• Jonathan Levin: Consumer Credit Is Soaring in the US. So What?

• Conor Sen: Wall Street Squirms While Main Street Gets Relief

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator and editor of the Lex column at the Financial Times, he is author of “The Fearful Rise of Markets.”

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