Markets approach the eye of the storm

Red Flag Warning Hurricane Storm Danger Dark Sea Clouds

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Storm clouds have been building on the horizon for months. Now they are reaching the shores.

The latest inflation data showed no respite. On top of that, the consumer is now starting to cut back on spending.

The good news is that the PCE data showed that inflation rates were not worse than expected. The bad news is that the pace of month-over-month inflation rose 0.6% from last month’s reading of 0.2%. Meanwhile, year-over-year PCE inflation rose 6.3%, the same rate as last month.

The consumer spending component came out much weaker than expected, while last month’s reading was revised lower, suggesting the consumer is starting to pull back.

The raw data may show this better when looking at the graph of consumer spending, which offers an apparent flattening and perhaps even shows signs of preparing to turn around and go down. It will make the data for the next two months critical. If consumer spending were to start rising, it would indicate that the risk of a recession has risen sharply.

US Personal Consumption Expenditures

Bloomberg

Bonds are worried

The bond market’s response is one of concern. Based on the reaction of the bond market, it seems that the risk of recession now outweighs that of inflation. 10-year breakeven inflation rates have been falling off a cliff recently and have dropped to 2.38%. The 2.25% to 2.4% region for inflation expectations has been a massive support region in the past. If inflation expectations fall below 2.25%, it would indicate that the market’s fear of a recession is genuine. At this point, inflation expectations are entering that support zone and should be watched for signs of further deterioration.

Bonds are worried

Bloomberg

Inflation expectations tend to be related to stock markets over time because rising and falling inflation expectations also indicate future growth expectations. Therefore, when inflation expectations fall, they suggest that future growth expectations decline. While not a perfect relationship, there is a relationship, and falling inflation expectations indicate slowing growth in this case, which is bearish for stocks.

US break-even point 10 years

Bloomberg

The slowdown aspect of growth and the process of raising rates by the Fed due to the still persistently high inflation rates pose the most important problems for the equity markets. The data that is likely to arrive over the next few months will continue to show high and persistent inflation rates. But the market is now anticipating the increased odds of a recession and falling inflation rates. With the Fed heavily dependent on data and in a sense hindsight and forward looking markets, it will increase the risk that the markets and the Fed will become disassociated which will create tremendous volatility in the market as the market becomes concerned about the Fed. tightening too much

Inflation rates may still be rising

The Cleveland Fed Inflation Nowcast projects a new cycle high for the June CPI on a year-over-year basis of 8.7%. An 8.7% print would be the main number the Fed is focusing on, according to the June FOMC meeting press conference.

Inflation rates may still be rising

Bloomberg

On the one hand, the market is now anticipating slowing growth and a possible recession, while the Fed is battling headline inflation rates. Based on the data in the chart below, it appears that inflation expectations are nearly two months ahead of headline inflation rates. For example, 10-year inflation expectations bottomed out in March 2020, while the headline CPI did not bottom out until May 2020. Meanwhile, inflation expectations peaked in April 2022, so the headline inflation rate may peak in June 2022.

CPI and inflation

Bloomberg

Even if inflation is peaking in June, it won’t stop the Fed from raising rates by 50-75bps in July. Based on the rate at which inflation expectations are falling now, it looks like inflation in July should start to fall rapidly. Still, even if headline inflation falls in July, the Fed will be forced to raise rates in September because inflation will remain well above its 2% average target rate. This will bring to the markets great concern that the Fed is too tight for a recession.

volatility explosion

These concerns will likely result in financial conditions tightening further. Based on the LQD to IEF ratio, which is a good indicator of spreads between corporate bonds and Treasury rates, and an indicator of financial conditions, we may be entering a period of much tighter financial conditions. and higher volatility that comes with those conditions. . The IEF/LQD ratio has been consolidating for a few weeks, but today was the first time it broke out of that trading range.

IEF/LQD ratio

business view

The IEF/LQD ratio is also highly correlated with the VIX index, and typically when the IEF/LQD ratio increases, there is an increase in the VIX index. It is probably no coincidence that the VIX index has also been consolidating for the past few weeks and has failed to give equity markets the last capitulation move lower.

VIX index

business view

If financial conditions start to tighten at a much faster rate, then it seems only natural that the VIX index would spike and the S&P 500 would have a big move lower.

In case there is not enough evidence to support the growing signs of a recession. the Atlanta Fed GDPNow Model forecasts a second-quarter decline in real GDP of -1% from June 30. That would be two consecutive quarters of negative real GDP.

Today’s data only seems to reinforce the idea that inflation is stubbornly high, which is a problem for the Fed. But at the same time, it’s clear that the consumer is pulling back and may even be showing signs of spending less in the coming years. months and potentially tip the economy into a recession, with markets entering a new area of ​​concern.

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