Energy Prices Dragging Headline Inflation Higher...Does the Fed Care?

To those in the US, welcome back from the most American of holidays. I’m sure there are other countries that have holidays largely devoted to gluttony, but as is often the case, America imported a good thing and made it better. Well, bigger and more gluttonous, anyway. Who else would have woven in nine hours of football and materialist retail bonanza into a celebratory feast day?  Heck, now you don’t even have to drive to a retailer at sunrise and risk getting trampled to death to grab the best Black Friday deals. You can do it while sitting on the couch! Well done, America. U-S-A! U-S-A!


I’m back at my desk after a travelling for a couple of weeks and spending much of last week considering, buying and preparing my contributions to the Thanksgiving Day feast.  The big story of the past two weeks has been the re-pricing of the front end of the curve in the US:


You don’t get a 30bp move in the 2y with the the 10y pinned in a 10bp range over a six week period without considering the message the market is sending to the Fed. Clearly there isn't much cooking in term premiums....the market hasn't lost faith in the lower natural rate, r*, or whatever you want to call it.




Which leaves us with this move in the front end, and what it all means. Please use the comment section to tell me what you think the market's message is...my two contributions would be 1) “there’s still a ton of liquidity out here”, and 2) “we don’t think the business cycle is sustainable, nor do we believe core inflation dynamics are going anywhere.”

Before this slips into another  “curve shape” post, it is the second message I want to focus on. While there has been little evidence that “demand-push” inflation is outside what we might expect at this stage of the business cycle, the buried message is related to big increases in oil, gas, and fuel oil prices since early this summer. As much as they will tell you these prices are “transient” and thus don’t impact monetary policy, they will likely be tough to ignore in 2018 because they will hit consumers in the pocketbook and push headline inflation higher.
We all know what the crude chart looks like, with the move from the low 40s to the mid-high 50s in WTI, roughly a 30% move. There has been a similar move in residential heating oil:


And as we come into the heating season, prices are tracking well above last year:


And inventories are approaching 5-year lows, which argues for big prices increases if we get a cold winter (that being said, I’m planning on running outside in a t-shirt today).


There have been similar price increases throughout the energy complex--gasoline tends to grab the headlines, and has been somewhat spared--but the marginal increase in global demand in 2017 has been the big story, and the impact on headline inflation is likely to show up in early 2018 just as the Fed is wrestling with what to do next. At the very least, these price increases have to play a role in the December Summary Economic Projections...the dots.


The FOMC will have a tough time justifying headline inflation projections aren’t rising, and they have a preternatural desire to write off energy-driven inflation as a transitory factor. But time and again energy is the tipping point for changes in the speed of the economy. It will be acting as a brake here...leading to the flattening of the curve. That combination has painted the Fed into a corner. Do they have the guts to continuing hiking if the economy is doing well, headline inflation is pushing higher, but core continues to lag behind?


It seems like the answer is yes...can they get away with four hikes in 2018? If so, 2x10s is going to zero….  

Absent a big move in core, what can change the demand for duration in the long end? Can this chart steepen the curve?




Or will US tax reform put a supply-side kick in the long-end? Supply doesn’t matter...until it matters. There will need to be a catalyst to change the narrative for buyers of duration...the demand side. I can’t see what it can be other than core inflation--probably on a global scale. While I continue to believe measures I have discussed in the past like the NY Fed’s underlying inflation gauge show there is price pressure in the economy, the market just won’t believe it until it really gets out of hand and forces the hand of not just the Fed, but of the ECB, BoJ, and even the PBoC.


Until then, the only thing out of hand is this flattening trend. And bitcoin.  

Shawn
TeamMacroMan2@gmail.com
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Gus
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November 27, 2017 at 4:40 PM ×

"In the past 40 years, it has typically taken 7 months for the yield curve to go from flat to inverted and then another 14 months for a recession to begin. On its own, a flattening yield curve is not an imminent threat to US equities. Under similar circumstances over the past 40 years, the S&P has continued to rise and a recession has been a year or more in the future." -- Urban Carmel, from today's The Fat Pitch post

http://fat-pitch.blogspot.com/2017/11/the-flattening-yield-curve-is-not.html

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johno
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November 27, 2017 at 5:50 PM ×

Agree the curve is no objection to being long stocks here, Gus. Otherwise not sure there's much to take from it other than market is fixed in its low neutral rate view. Actually, my guess is the the curve continues flattening until short rates are close to long, at which point short rates will drag up long. That's what happened in the last cycle and it makes some sense. Long end will want to see steady inflation around 2% before it goes much higher, and Fed Funds are only getting to 2% if inflation gets there (the blueprint Yellen layed out some time ago was to get to 0% real when inflation got to target).

Most notable piece of news today, IMO, was the Reuters sources story saying China likely to keep 6.5% target in 2018. Otherwise, the German SPD coalition news and the Dec 4 deadline for a Brexit offer.

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IPA
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November 27, 2017 at 8:04 PM ×

I dunno about all stocks going up though. Financials need a steeper curve and are going to be upset about 2s10s taking a trip to an IHOP.
Specifically, KRE is looking very toppy here. I still see it going down to backtest d/tops @ $46.

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checkmate
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November 28, 2017 at 9:53 AM ×

Your 1 & 2 are basically what I said to LB weeks ago in the case of do you trust the govt bond market to be a reliable judge of economic outlooks. I also suspect that bond markets would view the impact of energy on inflation to be less a cause for concern as they probably think energy sector up equates to sectors like clothing et al to be down as disposable incomes take the hit. So energy up is retail down ?
Other than that I'm with Gus post that yield curves are a test of patience for timing purposes. There again my portfolio is never a one or the other 'bet'.

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checkmate
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November 28, 2017 at 11:38 AM ×

Joining the dots of that previous post the one issue that breaks the bond market reasoning is if aggregate disposable incomes get the kind of uplift that makes price pass through a real inflation threat. That would bring us back to the two issues of tax policy and data on increases in earnings.

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Shawn
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November 28, 2017 at 11:44 AM ×

yes, my point is that energy inflation (beyond just what we pay for gas at the pump) is going to cause the fed to roll out the "transient" excuses again and test their commitment to hike in the face of higher headline figures despite lagging core inflation.

On the broader point, I don't think there is a causative relationship between the performance of the economy (or stocks) and the shape of the curve, except in the most extreme steepening cases (and to financials). I guess the curve shape isn't too far disconnected from what the Fed has been telling us about long-term interest rates, which is perhaps the most telling difference in this cycle compared to previous ones. Far shallower....but no shortage of financial excess.

Re: energy up/retail down theme, I'd say too much going on in retail to bet on that correlation, although from here I'd tend to agree with the idea.

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Skr
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November 28, 2017 at 2:29 PM ×

If you are unsure of what the bond traders are telling us, check out what the Dr Copper traders are telling us. Copper is off approx 5% from yearly highs and currently at the lower end of a channel on the weekly. One of them will give the answer.

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checkmate
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November 28, 2017 at 3:05 PM ×

There used to be a really good underlying rational for following the message of DR Copper. Not sure it's quite as applicable today. Maybe Madame Polyurethane as introduced a certain technological change to the issue.

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Rob
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November 28, 2017 at 4:00 PM ×

So 2014 the oil price fall leads to curve flattening and the 2017 oil price rise leads to curve flattening as well?

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Shawn
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November 28, 2017 at 4:52 PM ×

@Rob...yes! 2014-2016, global repricing of energy (and most commodities), EM stress, UST FTQ, wider credit spreads, fed on hold, lower for longer. bull flattening.

2017: higher global growth expectations, dramatically tighter credit spreads, still abundant liquidity, core inflation still in the gutter but FOMC hiking to offset easier financial conditions and expected uptick in core dynamics. Bear Flattening.

All that said, your point is a valid one, it does sound ridiculous and unsustainable. The more salient driver of the flattening trend stretches across both time frames and is summed up nicely in this presentation from Bullard a couple of weeks ago.

https://www.fedinprint.org/items/fedlps/293.html

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johno
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November 28, 2017 at 9:27 PM ×

GBP interesting, no? If markets can assume status quo for some years after Brexit, what you're left with is an economy with a central bank in motion, its inflation forecasts above target through the whole forecast period, and full-employment. A simple regression on 2Y spreads vs G10 since 2000 shows big undervaluation. Interesting setup ... got long recently through options but added some delta one exposure today on the Telegraph article. We'll see ...

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Buy Stocks
admin
November 28, 2017 at 10:04 PM ×

Oh my God, you lot are stupid beyond belief! Forget all this "macro" sh*t (which doesn't work). If you want to produce real Alpha you just buy stocks in size. SPX is going to double from here before we get a 50% re-trace, so I suggest you go long SPX (with as much leverage as your worthless risk managers will allow). You can thank me when you're retired next year.

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IPA
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November 29, 2017 at 12:31 AM ×

@BS, not sure why you assume that we don't own stocks. Most of us do. So your repetitive message of decrying us, "stupids", is inappropriate at best and quite offensive at worst. If you are so keen on teaching us how to do our work, why don't you give us five stocks which will outperform SPX for the next year and come back here on Nov 28 of 2018 to size up? Simply telling us to go long SPX and hold it until it doubles is like teaching us to get out of bed every morning. You come across as an arrogant SOB. Here are two things we would thank you for right now: shutting the f*ck up and leaving us alone.

Now, excuse me as I continue to vent about a more important issue... What is this crazy idea of raising taxes back up if the economic growth slows? I get the whole reasoning coming from the deficit hawks, but it is so flawed. One has to wonder if Cohn and Mnuchin were arm-wrestled by DJT to sign off on this nonsense in order to simply have the Senate pass the bill, any bill. Let me see... We are cutting taxes to stimulate growth but will raise them back up in the event the projected growth target is not attained. Say what?!! You don't raise taxes when economic growth slows as you will further hinder such to a point of generating even lower tax revenues. Even a fifth grader knows this.

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Shawn
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November 29, 2017 at 2:16 AM ×

Wow, easy there IPA...the year is almost over. I wasn't sure how much sarcasm there was in that comment so I held my fire, but I was going to say the buy SPX rant was amateur level trolling and that we really have higher standards and expectations around here. does amps have a seminar or a slide deck on this kind of thing?

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November 29, 2017 at 2:49 AM ×

Damn the crew is getting froggy in this thread...shittt son. Before I post my thoughts I gotta say @Shawn ur line asking if AMPS has a slide deck on this kind of thing is fucking hilarious. God I love that guy, he’s gonna come hard in the paint on you for that one!!!...@IPA come on u know that’s funny...I haven’t read the entire thread yet so I’m not trying to stir shit up...but that’s for real straight funny.

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IPA
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November 29, 2017 at 4:45 AM ×

Sorry, guys... I come here to exchange ideas, learn new things, brainstorm, listen to others with bright minds, all in pursuit of keeping sane in the world where brainless people are allowed to lead the masses. The last thing I need is one of these degenerates to repeatedly tell me how to "produce real Alpha" by going long the actual index I am supposed to beat. It's an oxymoron! Or is it simply a moron?

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November 29, 2017 at 7:06 AM ×

Just giving you a hard time brother...I feel u. Long the $SPX isn’t that the Grandpa Buffett call these days? I couldn’t look the investors (family office) in the face and give them a mgmt fee. More than .25 or less if that’s all I did. Same w our advsing firm man.

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checkmate
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November 29, 2017 at 8:47 AM ×

'sorry guys' really ?
I have to tell you these days I feel like I live in a world that is arse backwards. It seems the thing is to apologise for having a bad thought about anyone or anything. I don't get it. If a wanker wants to get into your life tell the fucker to crawl back into his hole and leave it that. He's free to do whatever he likes about it ,but the main thing is don't hand the twat a free license to think you'll just let him. Behaviour should have consequences and I don't mean apologies where none are required.

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Leftback
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November 29, 2017 at 3:04 PM ×

It's getting really insane out there.
Let's try to keep our wits about us and stay cool, calm and collected.

LB is inclined to fade today's moves in USDJPY and rates. That GDP revision is/was old news.
Rear view mirror investing never works out well.

CBs are going to want to burst the bitcoin bubble, trust me on this, it's classic tulip bulb stuff.
The question is what else will they bring down in the process of letting out some hot air?

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johno
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November 29, 2017 at 4:24 PM ×

Any views on likelihood of Irish border blowing up talks in the final stretch here?

These banks saying pound has no upside from here if we move to the transition talks are full of it, IMO. Question is how aggressive to get ... which hinges on Irish question now. Big in options and delta one, but former has me nervous ...

Oh, 10Y gilt futures are sell if you believe these r* estimators ... the annoying thing is they don't trade 24-hours, which is a strike against for small punters like me.

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Leftback
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November 29, 2017 at 4:34 PM ×

Bitcoin going past 10k to 11k reminds me of Spinal Tap. Turn it up all the way, Nigel.
A big reversal candle is forming in the NAZ. I suspect it will not be the last one this week.

Note that a stronger USD is now no longer automatically good for risky assets.
FX regime change afoot? If so, usually indicative of major infection points/turns in the markets.

If the USD and JPY start to rally together, the 12 y-o punters need to look out below.

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johno
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November 29, 2017 at 4:39 PM ×

Meant latter ...

Anyway, views welcome.

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Leftback
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November 29, 2017 at 5:10 PM ×

Momos are offered.

FB down 4%, NFLX off 6%. Fun.
The vol selling ETFs are off 3%.

We are synthetically long vol, via the short VIX universe.
Things could get messy for Chad, Brad and Thad.

:-)

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Shawn
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November 29, 2017 at 6:23 PM ×

ok, ok....sorry i threw some gas on the fire there. My apologies.

@leftback, per your point on USD, I read over the weekend that the quant guys at JPM have flipped the sign on the correlation of USD to inflation....stronger USD now implies higher inflation, because of capital flows, risk on, etc. etc.--they argue this impact is now stronger than that of lower import prices. Maybe not worth the paper (or electrons) it was printed on, but worth a thought.

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Leftback
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November 29, 2017 at 7:17 PM ×

Another piece by Peter Tchir on the perils of vol selling, consequences that might extend beyond the VIX complex itself:

https://www.forbes.com/sites/petertchir/2017/11/27/renaming-vix-the-greed-gauge/#767182ad7552

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