Trading Desk Talk

Top Line

• Key gauges of Inflation tell a mixed story
• Analyzing inflationary trends through the market cycle

Inflationary Metrics Mixed

Most of last week’s market focus was squarely on inflation data, namely the Consumer Price Index (CPI), Producer Price Index (PPI), and University of Michigan’s inflation expectation  survey. August CPI—the first in the trio of pricing pressure gauges—indicated that consumer prices rose by 3.7%. This is higher than the expected 3.6% increase, as well as the 3.2% increase in July. Core CPI, a measure of inflation that strips out more volatile food and energy prices, came in as expected at 4.3%. This is a slowdown from July’s 4.7% increase and a positive development for the Federal Reserve. August’s PPI figure was higher than expected at 1.6%, continuing the indicator’s rebound from a cycle low of a 0.15% increase in June. Core PPI continued to decline, falling from 2.4% in July to 2.2% in August. The final release of the inflation gauge trio were the responses to the inflation expectations survey, over both a short horizon (one year) and long horizon (five to 10 years). Short-term expectations dropped in September, from 3.5% to 3.1%, a welcome development for those expecting a pause from the FOMC. Similarly, long-term expectations, which came in at 2.7%, were down from 3.0% in August. With Fed officials in their blackout period, there is little to analyze in terms of how these datapoints will affect policy. Fed fund futures markets were effectively unchanged in their pricing of rate decisions. As of last Friday’s close, the likelihood of a pause at the Federal Open Market Committee (FOMC) meeting this Wednesday was 97%, while the likelihood of a November hike was 41%.

How Inflation Acts Through History – We have mentioned in past publications that monetary policy acts with long and variable lags. For this week’s Talking Points, we analyzed headline gauges of inflation, including last week’s releases, through economic cycles and have summarized our findings below.

From a macro perspective, inflation tends to prevail only once the economy begins to heat up. This process takes time; on average, pricing pressures reveal themselves late in an economic expansion. We illustrate this point below, using data starting in the 1970s to show the quarterly change in core CPI in past economic expansions.

From a micro perspective , owners’ equivalent rents (OERs), which represent over a quarter of the core CPI index’s weighting, tell a similar story. Because OERs—which measure how much an owner would need to pay to rent a comparable unit—have only been published since the early 1980s, just three major economic cycles were available for our analysis. Note that OERs are important for two reasons: 1) they constitute a large weight in the core CPI index, and 2) they tend to carry a large “momentum coefficient” (i.e., they tend to maintain a trend until the economy shocks them into a different direction; OERs then follow the new path until the next shock, rebounding between trends). According to last Wednesday’s CPI release, OERs put in their fourth consecutive slower print  after having climbing unimpeded since early 2021. History thus suggests that we should expect this current OERs trend to continue, given the restrictive rate environment (which, itself, is an indication that the economy is either in the late stage of the expansion or early stage of a recession).

Tightening cycles tend to begin with a shift in the Fed’s focus, from ensuring maximum employment to providing price stability; inflationary fears rise during this period, but the level of inflation may not yet be of great concern to policymakers. Stated differently, inflation tends to pick up somewhat slowly at first, and the Fed takes small steps to address pricing pressures. As noted, tightening campaigns are brought on by rising inflationary pressures, which occur in the later innings of an expansion. The eventual acceleration of pricing pressures from the first third to the middle third of the cycle reflects the “reaction function” of the Fed, a topic discussed in previous Talking Points. The FOMC tends to tighten slowly at the beginning of the cycle, enabling the economy to accelerate despite more restrictive policy. The final third of tightening campaigns, however, tends to reflect the effects of restrictive policy—with growing, then finally slowing, inflationary pressures.

This cycle we saw the Fed embark on one of the most aggressive tightening regimes in its history. As such, inflationary pressures receded from their peak faster than in previous cycles: The annualized growth rate of inflation peaked around 3.67% during the current tightening (compared to 3.69%, on average, in past tightening cycles), before slowing sharply to just over 3.30%.

In recent decades, there has also been a structural trend toward lower inflation. In times of both easing and tightening, pricing pressures have broadly declined with each successive cycle.

From the Desk

Agency CMBS – Another quiet week in Agency CMBS left spreads effectively unchanged across the board. Origination volumes were low with over $500 million of Fannie Mae DUS out for auction. For context, average weekly DUS volume for 2023 is over $700 million. Freddie Mac’s new-issue volume picked back up after short hiatus in August, with three deals—one Conventional, one Small Balance, and one Tax Exempt—priced throughout the week. Freddie also auctioned around $500 million of Participation Certificates (PCs) which were absorbed well by the market.

Municipals – AAA tax-exempt yields were relatively flat across the yield curve, week-over-week.  Municipal bond funds saw back-to-back weeks of outflows with $117 million leaving the market last week (high yield funds saw outflows of $11 million last week). Last week again saw a light volume of new issuance and this coming week with the Fed meeting this coming week expect another light week of deals coming to market.  Supply of new deals going forward will be dependent on factors such as possible rate hikes from the Fed as well as how long issuers/borrowers can wait to start their projects depending on cash on hand.  In the near term, expect spreads to the AAA Municipal Market Data (MMD) yield curve to continue to remain tight, especially on highly rated deals such as cash collateralized deals that are rated Aaa by Moody’s.

The Week Ahead

Without a doubt the main focus of markets will be on Wednesday’s FOMC meeting, expected to culminate in no change to the Federal Funds rate. While this pause is all but priced into markets, at least according to Fed Fund futures, investors will be dissecting the policy statement released at 2:00 p.m. EST and analyzing every word from Fed Chair Jerome Powell at his 2:30 p.m. EST press conference. The economic calendar is relatively light, with Housing Starts, Building Permits, Jobless Claims, Existing Home Sales, and S&P Global U.S. Manufacturing as well as Services PMIs being released throughout the week.

Economic Calendar

Summary of Global Fixed-Income Markets

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