Expectations Convergence

The January Effect

The last three January employment and CPI reports have been hotter than expected, and like the recurring pattern of soft 3Q and stronger 4Q employment growth following the Lehman bankruptcy, we suspect the pandemic-distorted seasonal adjustment factors are overstating the strength in the labor market and inflation data. That said, the sustainable broadening disinflation FOMC participant narrative and our quadrilemma (4% unemployment plus 4% wage growth facilitating a year-end ‘24 4% policy rate and 4% 10-year Treasury) were dealt a significant setback by the January employment and CPI reports, distortions or not. We will dig into the details of this week’s inflation reports later in the report, but in short, the 2H23 disinflation is highly concentrated in core goods prices that appear to be bottoming, and non-housing services inflation in the CPI and PPI reports reaccelerated in 2H23 amidst a setback in the recovery in the supply of labor. We expect cooler data in the coming months, but with the manufacturing and residential real estate sectors looking increasingly likely to expand in ‘24, and no signs of consumption weakening despite the January retail sales undershooting consensus, the hurdle for the FOMC beginning to reverse the policy tightening increased over the last couple of weeks.

A year ago, the Fed had slowed the pace of hikes from 75bp to 25bp, until the January data led the Chair to suggest in his early March Monetary Report to Congress, the FOMC might need to reaccelerate the pace to 50bp hikes. That suggestion caused a spike in real rates (TIPS yields) that exacerbated the Silicon Valley Bank run on uninsured deposits. The equity and fixed income market’s quick stabilization following the setback in the sustainable broadening of disinflation this week is a function of the convergence of the Fed and market expectations for the ‘24 policy rate path. In other words, investors took comfort that the FOMC wasn’t surprised, but what market and FOMC participants are missing is the implication of sticky services inflation for the terminal policy rate. If the FOMC only gets to 4% by the end of 2025, an increasingly likely outcome we discussed in last week’s note, The Wrong Price, pressure on banks, small businesses, real estate and federal finances will intensify. In short, 4.25% 10-year nominal Treasuries and 10-Year TIPS at 1.90%, with a -6bp term premium, are — in the words of Lee Cooperman — ‘returnless risk’ if the ‘24 year-end is likely to be 4.75% or higher. Additionally, the bounce in small caps and regional banks post-CPI is also misguided; as we discussed last week, the 200bp hit to bank return on common equity to the 10% threshold where banks build or burn capital, requires yield curve disinversion and a scrapping of the regulatory capital increase proposal to make a ‘healthy broadening’ sustainable.

Figure 1: Core retail sales (control series) missed expectations reducing the Atlanta Fed PCE and GDP tracking models by 50bp to 2.7% and 2.9%. The headline number is nominal, we deflate the series using core goods ex-autos, because of goods deflation the real was greater than nominal. In ‘21 and ‘22, November and December were surprisingly weak, and January beat. The opposite was true over the last three months. It is not clear based on the composition that weather suppressed sales, however given the impact on the employment report, it likely did.