A Grim Picture of Inflation

Fed Funds Futures (ZQ) ZQ1! , 2-Yr Yield (2YY) 2YY1! , 10-Yr Yield (10Y) 10Y1!

This is the third report in the series “Year of the Rabbit: Short-tailed Trading”.

US Consumer Price Index (CPI) declined 0.1% in December 2022 on a seasonally adjusted basis, after increasing 0.1% in November, the U.S. Bureau of Labor Statistics reported on Thursday, January 12th. Over the last 12 months, the headline CPI increased 6.5%. The inflation index for all items less food and energy rose 0.3% in December, after rising 0.2% in November. The Core CPI increased 5.7% year-over-year.

December is the only month in 2022 when aggregate price falls below prior-month level. The headline CPI is now 0.5% lower than a year ago on an annualized basis.

Cooling inflation is welcoming news to consumers, businesses, and investors. It also gives the US Federal Reserve more flexibility to moderate its hawkish monetary policy.

Inflation by Category Data Paints a Different Picture
The December CPI data was a “one-man show”. Gasoline price declined 9.4% in one month, bringing its annual change to -1.5%. After an all-time high record of $5/gallon reached in June, we ended 2022 with lower gasoline price year-over-year.

If you think we are getting relief in energy cost, nothing could be further from the truth.
• Fuel oil dropped 16.6% in December, but it is up 41.5% for the year
• Electricity price went up 1% in December and +14.3% for the year
• Pipelined natural gas were up 3% monthly and +19.3% yearly
Americans are getting bigger utility bills to light up the room and heat the house this winter.

Other essential items:
• Food cost +0.3% in December and +10.4% Y/Y in 2022
• Shelter cost +0.8% monthly and +7.5% annually
• New cars cost 5.9% more but used cars are 8.8% cheaper in 2022

Inflation is certainly on the way down, but it is sticky. Many product and service items essential to household living and business operation are far from under control.

Interest Rate Outlook for 2023
After the release of new CPI data, market consensus centers on a modest 25-basis-point increase on February 1st., which would bring the Fed Funds rate up to 4.50-4.75%. I also expect another 25-bp raise on March 22nd, setting the so-called terminal rate at 4.75-5.00% for the rest of 2023. This is my baseline forecast for 2023.

The previous section shows that inflation is still uncomfortably high for food, housing, and energy to power the home, as well as for new vehicle. The Fed’s job for fighting inflation is far from over. I do not expect any rate cuts to occur in foreseeable future.

When it comes to central bank monetary policy, there is a lagging period before it works its way through the economy. The response lag could be anywhere from 6 to 12 months. By my estimate, it takes about 7 months in this rate-hike cycle.

The Fed initiated the first increase in March, but inflation did not peak until June at 9.1%. Monthly CPI was unchanged the following month. However, the slowdown was solely due to a sharp decline in gasoline price, not attributable to the Fed.

Core CPI topped 6.6% in September, then subsequently moved lower to 6.3%, 6.0% and 5.7% in the fourth quarter. October was the first month when core inflation reverses its rising path. This is where I mark the start of inflation response to monetary tightening.

Once the Fed reaches its terminal rate, the force of inertia would carry the policy impact on inflation for several more months. That’s why the Fed is likely to keep the rate unchanged for the remainder of 2023, measuring the policy effect.

Fixed Income Investment Opportunities
On “The Real Cost of Fed Rate Hikes”, published on July 25th, I spelled out the impact of interest rate increases to households, corporations, Federal and local governments.

With the risk-free rate expected to reach 5%, all borrowing cost will go up further, even after they rose significantly last year. As the economy slows down, those with high debt loads may not make it through this downturn.

If you plan on investing in bonds, default risk should be on the very top of your mind. Consider safe play: Avoid any issuer with a high debt-to-equity ratio. Corporate high-yield, municipal bonds, and securities backed by adjustable-rate mortgages and credit card balance fit this bill.

JPMorgan Chase took notice. On Friday the 13th, JPM JPM posted revenue that beat expectations, but the biggest US bank warned it was setting aside more money to cover credit losses because of a “mild recession” is its “central case.” The bank posted a $2.3 billion provision for credit losses in Q4, a 49% increase from the 3rd quarter.

For relatively safe investment options, bank certificates of deposits (Jumbo CD) and high-quality corporate bonds (rated A or above) offer yields from 4.50% to 6.0%. They could beat inflation in the coming years.

Spread Trade Opportunities
We have been in a negative yield-curve environment since July. In my opinion, slower rate hikes weaken the force that drives short-term yield rising faster than long-term ones. Once the Fed actions are over, mean reversion could occur so long as we do not fall into a deep recession.

A Refresher: Yield curve plots the interest rates on government bonds with different maturity dates, notably 3-month Treasury Bills, 2-year and 10-year Treasury Notes, 15-year and 30-year Treasury Bonds.

Bond investors expect to be paid more for locking up their money for a long stretch, so interest rates on long-term debt are normally higher than those on short-term. Plotted out on a chart, the various yields for bonds create an upward sloping line.

Sometimes short-term rates rise above long-term ones. That negative relationship is called yield curve inversion. An inversion has preceded every U.S. recession for the past half century, so it’s seen as a leading indicator of economic downturn.

On January 12th, 2-year T-note is quoted at 4.20% in cash market, while the 10-year T-note is priced at 3.61%. This measures the 10Y-2Y yield spread at 59 basis points.

The negative yield curve could become less inverted, then change to a flat yield curve in the coming months. It could reverse back to an upward sloping normal yield curve in 2024. Here are my reasoning:
• Easy money created by record government spending kept the borrowing cost low. This was a main reason why longer-term yields rise less than short-term ones.
• The new Republican-controlled Congress would stall the approval of big-ticket expenditure bills. Closing the flood gate could bring the borrowing cost back up.
• After the depletion of low-cost capital, lenders will have no choice but to raise the long-term lending rate above the short-term deposit rate.

CBOT Micro Yield Futures offer a way to express your view on future yield direction. You could also observe how the expected yield spread changes between 10Y and 2Y.
On January 12th, February Micro 10Y Yield Futures (10YG3) was settled at 3.446. February Micro 2Y Yield Futures (2YYG3) was settled at 4.081. The 10Y-2Y spread is -63.5 basis points.

Micro Yield Futures are notional at 1,000 index point, with each point equal to 1/10 of 1 basis point and value at $1. For example, if the 10Y-2Y spread narrows to -40 basis points, your position would gain $235 (= (-40+63.5) x 10) if you long the spread.

To trade Micro Yield futures, margins are $375 for 10Y and 2YY. A long spread can be constructed by a Long 10Y and a Short 2YY positions.

Happy trading.

*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.

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