Last July, Gang Hu, a trader of Treasury inflation-protected securities and related derivatives instruments, warned that “inflation is going to be stickier than most people imagine.”
Those prescient words held up in Tuesday’s U.S. CPI report. While the annual headline CPI rate slowed for a seventh straight month, to 6.4% in January, the data contained enough signs of sticky inflation that many in financial markets nudged up their calls on where the Federal Reserve is likely to end its interest rate-hike cycle, to between 5.25% and 5.5% for the fed funds rate.
See: CPI shows U.S. inflation still sticky and slowing grudgingly in January
The data disappointed investors who had expected to see more definitive signs of easing inflation by now, following eight straight rate hikes by the Fed since last March. Energy services and shelter were two of the CPI components emitting worrisome signs of persistent inflation.
Hu of New York hedge fund WinShore Capital Partners came away with these four takeaways from January’s data:
- It could “easily take more than a year” for inflation to meaningfully decline by enough to prompt policy makers to their benchmark interest rate once they reach 5.25% to 5.5%. That’s a roundabout way of saying rates could stay that high in 2024, up from the current level of 4.5% to 4.75%.
- Rate hikes thus far aren’t having the same impact on the economy as they used to because Covid has taken millions of people out of the workforce, boosting job availability relative to the number of job seekers. Economic growth will have to come down by even more than expected to put a dent in inflation, Hu said.
- Key parts of the inflation market, namely the Treasury inflation protected securities (TIPS) market, may be incorrectly concluding that the Fed is going to be in control of inflation. The TIPS market is indicating that inflation will go back to the Fed’s 2% target within a year, and that policy makers will maintain control for the next 30 years, in Hu’s estimation. He says the TIPS market is working on the assumption that the Fed’s will power is very strong when it comes to arresting inflation. As of Tuesday afternoon, 5-, 10- and 30-year TIPS rates were hovering either at or below 1.5%, according to Tradeweb. On a breakeven basis, though, they are implying less-than-2.5% CPI inflation rates, according to Hu.
- CPI fixings, or derivatives-like instruments, currently suggest that the annual headline CPI rate could gradually drop to below 3% by September, but that “could very well be wrong,” the trader said.
“A key question for us to be asking now is, ‘What is the steady state of inflation after all is said and done?” Hu said via phone on Tuesday. “In other words, we’ve gone through a lot of goods inflation because of Covid-induced issues, and we have a 5% rate that will still have to hit the economy. So what is the rate of inflation that we are going to see after everything settles? That number is going to be crucial and that’s the question the capital markets need to ask. The market will have to reach a consensus or some sort of call on what this is because it will determine where the Fed stays with rates.”
For his part, Hu said he hasn’t decided what that steady state number should be yet, though it may be around 3% as long as energy costs stay roughly where they are; alternatively, the number will be much higher if they don’t. Inflation expectations are also key because the longer that price gains stay elevated, the longer inflation gets entrenched, he said.
“My personal judgment is that the Fed is not going to 2% inflation very quickly, but I don’t see flyaway inflation either,” Hu said. “The Fed, for right or wrong reasons, is likely to stay at 5.25% or 5.5% with rates in 2024, even if you think the steady state of inflation is 4%.”
As of Tuesday afternoon, all three major U.S. stock indexes
were down, led by a 0.7% drop in Dow industrials, as investors weighed the risks of persistently higher borrowing costs. Rates on 6-month
and 1-year T-bills
surpassed 5%, as Treasury yields all moved higher. The policy-sensitive 2-year rate
swung around a 20-basis-point range, while the Treasury curve inverted further below zero.
Monetary Policy Analytics in Washington, led by former Fed Gov. Larry Meyer, is one of the firms that’s changed its expectations for the terminal fed-funds rate, to 5.25%-5.5% from a prior call of 5%-5.25%. Meanwhile, analysts at BofA Securities
said the risks are tilted to the upside on their call for a 5%-5.25% fed-funds rate.