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A counterargument is developing in financial markets on the most likely path ahead for U.S. inflation, and it’s one that would likely come as a big surprise to many investors and policy makers.
It’s the idea that inflation, as measured by the annual headline rate on the consumer-price index, is set to fall below 3% after the next handful of months and stay in the vicinity of 2% for the entire second half of 2023. Traders of derivative-like instruments known as fixings, who are seen as the financial market’s brightest minds on inflation, are penciling in such a scenario for this year. They’ve been close to the mark on their forecasts during inflation’s run-up from 2021 to 2022, though they’ve also missed downside surprises.
Source: Bloomberg
“We are in the same camp as fixings traders and see a tremendous amount of weakness in the economy and a direct correlation between the shrinking money supply and inflation,” said Tom di Galoma, managing director and co-head of global rates trading at BTIG LLC in New York.
“People do not want to continue to pay high prices and there’s a real threat that inflation comes down toward the 3% handle this year,” di Galoma said via phone Wednesday.
“I’m looking for another 25-basis-point Fed rate hike in March, with rate hikes over from there and lower inflation being the big narrative. The inverted yield curve is telling me something severe will happen in the economy,” and the recent decline in inflation in countries like India “leaves me pretty much confident inflation is going to drop here,” he said.
The notion that inflation could approach levels close to the Federal Reserve’s target of 2% within months is one that hasn’t been discussed much publicly — not even by central bankers themselves.
The consensus view on inflation is that it’s likely to remain elevated anywhere between 3% to 6% for some time, which will prompt the Fed to keep hiking interest rates and leave them there — boding poorly for risk assets. Indeed, some traders and strategists are focused on the competing argument that the U.S. could be heading into a period of “transitory disinflation,” in which any improvement in price gains will turn out to be fleeting.
See: Top Wall St. economist says ‘no landing’ scenario could sink stock-market rally
The year-over-year CPI rate fell to 6.5% in December from a 9.1% peak last June, raising hopes that further declines are on the way and that financial markets can recover from 2022’s dismal performance in stocks and bonds. January’s CPI is set to be released next Tuesday. While the Fed’s 2% inflation target is attached to another inflation gauge — the personal-consumption expenditures price index — policy makers pay attention to the annual headline CPI rate because it impacts household expectations.
Behind the counterargument in favor of a swift, surprising return to more normal, prepandemic levels of inflation is the view that the U.S. economy won’t be able to avoid a recession and that such a contraction is bound to bring a swift decline in price gains.
On Wednesday, financial markets were digesting a string of remarks by Fed policy makers in the past few days — all pointing to the need to keep up the fight on inflation.
New York Fed President John Williams said the central bank will likely need to keep interest rates high “for a few years” to kill off inflation, while Fed Chairman Jerome Powell said on Tuesday that January’s blockbuster job gains underscore the need to keep raising interest rates. Powell said he expects inflation to drop back down to around 2% by 2024.
As of Wednesday afternoon, all three major indexes
DJIA,
SPX,
were lower, led by a 1.4% drop in the Nasdaq Composite, and Treasury yields were mixed. Rates on 6-month
TMUBMUSD06M,
and 1-year T-bills
TMUBMUSD01Y,
inched closer to 5%, in line with expectations for the fed-funds rate.
At Pennington Partners & Co., a Bethesda, Maryland-based multifamily office that oversees $2 billion, Sumit Handa, co-head of the firm’s investment committee, said that a swath of the U.S. economy — from housing to commodities and auto sales— is pointing to a slowdown and that January’s job gains were an “aberration.”
“Our view is that the Fed is somewhere near the end of its rate hikes, and we think the consensus is wrong about the timing of inflation’s decline,” Handa said via phone. “We see a decline in inflation — with rate hikes leading to a challenging environment for anyone who borrows — resulting in deflation in the second half of the year. We believe a recession is likely in six to nine months.”
“I can’t tell you what will happen next month or next week, but I can suggest that the economy is weak,” he said. “Further, with inflation coming down, this bodes well for consumer confidence and [is] partly why there has been a rally in risk assets” during January.
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