Survey-based and market-based measures of inflation expectations are starting to decline, and the market believes that the Fed will get inflation down to the FOMC’s 2% target, see charts below.
Inflation Expectations Coming Down
Why Alternatives?
Check out the latest episode of “The View from Apollo” where our Chief Economist, Dr. Torsten Slok, speaks with Matt O’Mara, Partner and Portfolio Manager here at Apollo.
In this episode you’ll hear Torsten and Matt’s thoughts on why investors should be moving beyond the public markets and incorporating alternatives into their investment portfolios. Is the 60/40 portfolio dead? Tune in to find out.
Who is Buying Treasuries?
With rates rising and the dollar going up, foreign private investors are buying US Treasuries at a record pace, see chart below.
Recession Probability Rising
The consensus now sees a 50% probability of a recession in the US and 60% chance of a recession in Europe and the UK, see chart below. Investors should be positioned accordingly.
Hitting the Brakes
Last week, the market expected Consumer Price Index (CPI) headline inflation to come in at 8.1%, but instead, it came in at 8.3%. This is still lower than the 8.5% from the month prior, but still higher than anticipated—which took markets by surprise. The bottom line is that inflation is not coming down as fast as the Federal Reserve would like. As a result, we can expect more rate hikes, and possibly higher interest rates for longer. The consensus was expecting a rate increase of 75 basis points at this week’s FOMC meeting. But given last week’s CPI data, financial markets are now pricing in a hike as high as 100 basis points—a full percentage point. This would be a significant development, and a strong indication that the Fed is poised to step even harder on the brakes going forward.
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Inflation Mainly Driven by Supply
US and European inflation for the past two years has been almost identical despite the fiscal response to covid being double the size in the US relative to Europe, see charts below.
With a much more aggressive fiscal response in the US, both headline and core inflation should have been much higher in the US today than in Europe.
The identical path of inflation in the US and Europe strongly suggests that inflation is not driven by demand but instead by supply problems associated with covid. Some of these supply problems for goods will get resolved quickly as supply chain problems ease. But other supply problems in the labor market will take some longer time.
The implication for markets is that the Fed and the ECB may not need to do much demand destruction to get inflation down.
This topic is also debated in several Fed working papers at the moment, see here and here.
S&P500 today vs 2008
There is a striking similarity between how the S&P500 has traded during this period of high inflation and the pattern we saw during the financial crisis in 2007-2008, see chart below. Maybe one conclusion is that when investors are faced with extreme levels of uncertainty, the behavioral response in financial markets over time is relatively similar. Markets think the problems are over and want to go higher but as more data comes in, then realize that the shock is still here and the downside risks are still substantial. Our latest Slowdown Watch is available here.
Comparing Housing Markets
The share of renters is higher in Germany and France than in the US, and the share of households with a mortgage is higher in the US than in most other OECD countries, see chart below.
Net Supply of Treasuries Growing
The annual net supply of Treasuries before the pandemic was $500bn. In 2023 it will be $1.5trn, with $1trn coming from the budget deficit and $500bn coming from Fed QT, see chart below.
This increasing supply of Treasuries is at risk of crowding out demand for other types of fixed income, including IG, HY, loans, and mortgages, in particular as the level of the risk-free rate continues to increase.
The upward pressure on rates because of the higher net supply of Treasuries is in addition to the upward pressure on rates coming from higher inflation.
The bottom line is that there is upside risk to rates not only from inflation but also from the growing supply of Treasuries, and the growing supply of Treasuries trading at higher rates could lower demand for other fixed income assets.
SPR Release Weighing on Oil Prices
The US releases about 1mn barrels of oil daily from the Strategic Petroleum Reserve, and the SPR inventory is now at levels last seen in 1984, see charts below.
