The Fed is about to trigger a significantly harder landing than they intend. If they truly want to bring inflation down to 2%, a severe downturn would be inevitable. Another leg down in financial markets is to be expected.
We wrote last month that we were feeling less pessimistic than we had been earlier in the year, when we warned that crash risk was at its highest since the sub-prime crisis of 2007. It wasn’t that much had changed in our thinking, but with equity markets around 25% lower, crypto markets 70% lower, credit spreads on the wider side of their historical norms and convexity no longer cheap, we felt that the risks were more symmetric.
«If there was going to have been a crash,» we reasoned, «there would have been one by now.»
That might have been premature. We’ve felt for some time that inflation is a bigger problem than it looks, but we also felt the Fed were not willing to do what would be necessary to bring it down.
As we’ll explain below though, after Jerome Powell’s Congressional testimony in late June, in which he nailed the Fed’s credibility to being able to return inflation to 2%, we’re now not so sure. Moreover, and notwithstanding the market pain suffered already this year and credit spreads on the wider side of historical ranges, the steepness of credit curves suggest markets are still not reconciled to the likely hard landing ahead.
We’re still nervous and will remain so until the Fed blinks.
One perennial problem with measures of CPI inflation is that they tend to be driven by the noisiest components. This is why there are so many different ‹core› measures, each aiming to capture the ‹underlying› inflation rate by excluding the more volatile or controversial components (e.g. food, energy, used cars, shelter).
Those exclusions are arbitrary though, so we look at reconstructed CPI which reweights components according to the inverse of their volatility. Noisier components are weighted proportionately less than less noisy ones, but never arbitrarily zero.
Chart 1 shows that unlike the Bureau of Labor Statistic’s traditional measure of core CPI (ex food & energy), our inverse volatility measure has continued to accelerate this year.
Chart 2 shows that the percentage of sub-components which are higher than they were last year remains highly elevated.
Admittedly, these measures are backward looking. If we look forward, it’s striking that there’s been no pricing in of any change in the inflation regime. Chart 3 shows that forward inflation pricing derived from the CPI swaps market is consistent with historically average inflation expectations...
...while Chart 4 shows that the forward curve has actually shifted down this past month. The market continues to price in the old inflation regime:
We’ve long argued that achieving such a return is plausible provided the Fed is willing to tolerate or even deliberately engineer a deep recession. However, since we haven’t felt any willingness to go down this route (e.g. the wishful insistence that a 3-3.5% fed funds rate is somehow «neutral»), we’ve ultimately felt that that if push came to shove they’d rather accept a higher rate of inflation.
Now we’re not so sure. During his Congressional testimony in late June, the Chairman was asked about this possibility, and specifically whether or not the Fed would be open to raising the inflation target.
His response was emphatic: «That’s just not something we would do.»
When asked if he would cut rates in a scenario where unemployment was rising but inflation remained high, he was equally robust: «We can’t fail on this, we really have to get inflation down to 2%.»
What would the transition back to a 2% inflation world look like? Today’s core inflation (on our measure) is around 5.5%, so for the Fed to deliver on Powell’s promise the inflation rate would need to drop by around 3.5 percentage points. However, for any given sustainable inflation rate (i.e. an average ‹through-the-cycle› inflation rate) there is likely an undershoot during a slowdown/recession.
Thus, if that rate is 2%, we might expect inflation to trough at something like 1% during a recession. That means we’d expect inflation to have dropped by 4.5 percdentage points by the trough of the next slowdown. But this didn’t even happen during the Global Financial Crisis of 2008!
Indeed, Chart 5 shows that such a decline has historically only happened during extremely deep recessions (two in the 1970s, one in the early 80s and one in the early 90s).
During said testimony, Powell reassured lawmakers that the Fed continued to expect a strong economy – which to us simply isn’t compatible with a return to 2% inflation.
How to reconcile? The Fed is about to trigger a significantly harder landing than they intend.
To what extent are markets now pricing this? Markets have fallen heavily this year and, as we said earlier, credit spreads are on the wider side of their historic ranges. According to BAML-ICE, the option-adjusted spread (OAS) for BBB rated 7-10 year cash corporate bonds in early July stood at 219 basis points, compared to an historical median of 189. Credit is «cheap», if hardly compelling (Chart 6).
Interestingly though, the steepness of credit curves remains historically elevated, suggesting markets are shifting their default expectations further out into the future.
This is consistent with the interpretation that having taken advantage of record low rates during the pandemic to push maturities out until 2025 and beyond, near-term corporate default risk is low. The year-to-date rally in commodity markets and the rude financial health of energy issuers is also a factor.
However, most defaults don’t actually happen because of difficulties in refinancing. They happen because operational leverage exhausts working capital (as would likely be the case if the central bank tried to drop the rate of inflation by 4.5 points). As Chart 7 shows, during times of stress, credit curves invert as problems which had been thought to be non-pressing suddenly become immediate.
Thus, although spreads are wider than historical norms, the ‹value› is primarily at the longer end of credit curves. If nothing else, such steepness suggests credit markets are offering cheap protection against an accidental recession.
More likely, we think, is that we can read this across to broader complacency in the pricing of risk assets. We hence expect another leg down.
Dylan Grice’s Popular Delusions, a twice monthly investment report that includes investment ideas ranging from macro, sector and individual securities can be subscribed to via www.calderwoodcapital.com