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Good morning. Jay Powell struck a hawkish tone in a speech yesterday. Bond yields rose only slightly in response, and stocks held their nerve. It seems that the markets have already taken into account the Fed Chairman’s comments. Sometimes markets follow politics and sometimes politics follows markets. The trick is knowing what era you live in. Email us: [email protected] and [email protected].
The discourse on inflation could quickly reverse
Jay Powell is worried about inflation again. He was there yesterday:
We said it to [Federal Open Market Committee] that we will need greater confidence that inflation is moving sustainably towards 2 percent before it is appropriate to ease policy. . .
Recent data has clearly not given us greater confidence, but rather indicates that it will likely take longer than expected to achieve this confidence.
The bond market had already panicked last week, after the release in March of a third consecutive report on consumer price inflation, even though long-term yields closed on Tuesday at a 2024 high. Together, Powell’s comments and rising yields add to the growing evidence of a shift in mood (ahem, reversal in sentiment) that has taken place over the past month, as we noted yesterday.
But it’s good to remember that Powell is a lagging indicator. He and his colleagues are committed to “data addiction,” meaning they are led wherever the latest inflation numbers take them. To cite just one example, less than a month ago he dismissed the January and February inflation reports, saying they “didn’t really change the big picture.” The March numbers have changed his tune for now. But Powell’s harsh sounds yesterday could easily become serene tomorrow.
We believe the risk of an about-face in the inflation narrative over the coming months is particularly high due to the dominance of housing sector inflation. Housing has long been the largest category of inflation, but its importance has continued to grow as non-housing prices have stabilized. In the consumer price index, most of the remaining inflation overrun is in two categories: auto insurance and housing. In the personal consumption expenditures index, targeted by the Fed, it is only housing; the basic PCE excluding housing stands at 2.1 percent.
Remember the history of housing inflation. Official data covers paid leases, including newly signed and existing leases. This gives a better measure of the cost of living, but a worse barometer of real market conditions; Conversely, rental data from private providers like Zillow captures newly signed leases and is therefore more current. With rent inflation on new leases appearing relatively moderate, many expect the official data to converge after some time. Initially, this lag was supposed to be around nine to 12 months, but that didn’t happen:
It’s unclear why it’s taking so long. Some say it’s just noise: Zillow and other new lease data have a short history, and their relationship to the CPI is poorly understood. Others say it’s a signal that unaffordable housing prices, expensive mortgages, low unemployment and/or increased immigration are keeping the rental market hot.
We’d split the difference: The rental market is pretty strong, but the CPI isn’t immune to a 5 percent annualized rate. Using monthly rates is helpful for comparisons here. In the latest CPI report for March 2024, housing inflation increased by 0.42 percent, a level comparable to that seen since March 2023. In normal times (including strong rental markets), monthly housing rates typically range between 0.2 percent and 0.3 percent; in 2017-19, the average was 0.26 percent.
In short, there are (still) compelling reasons to believe that housing inflation will fall further. Although it hasn’t happened yet, we could turn a corner at any time.
What would happen to broader inflation if this happened? One way to visualize it is to look at the excessively high CPI data from the past three months, which was driven not only by housing, but also by skyrocketing prices for auto and hospital services. Even then, more normal housing inflation would have offset gains elsewhere. The chart below simulates the last three basic CPI reports under different monthly housing inflation assumptions:
We are not completely calm about inflation. Prices for supercore PCE (that is, excluding basic housing services) have increased 5 percent over the past three months and 4 percent over the past six months. This figure is too high for the Fed, likely reflecting wage growth that has normalized more slowly than the broader labor market. But wage growth is indeed falling. With that in place, all it takes for the inflation narrative to move from “stubborn” to “gradually falling” is the long-awaited change in protection. (Ethan Wu)
Banking earnings
Banks are the most economically sensitive companies. They earn a spread by acquiring money at a lower price and lending it at a higher price. The biggest risk of this model is that borrowers default on their loans, a risk amplified by the fact that banks are highly leveraged. The rate of borrower forgiveness depends on macroeconomic conditions. So, if you’re wondering whether the economy is improving or getting worse, look at bank performance, particularly credit quality.
So it’s been a little strange to hear banks talking about their first quarter results in recent days. Neither the national giants (JPMorgan Chase, Bank of America, Wells Fargo, Citigroup) nor the regional players (PNC, M&T, and others) have had much to say about the economy’s effect on the quality of credit. Analysts haven’t asked many questions about it either.
This essentially reflects the fact that the US economy is, overall, very healthy. There are few disasters worth talking about, other than office real estate, and this disaster is moving at a politely glacial pace. This allows analysts to question their two current concerns, both technical and delicate: when the increase in deposit costs, driven by depositors slowly realizing that they are not obliged to accept interest rates zero, will it reach its maximum? And, for the biggest banks, will they be able to free up capital and use it to buy back shares when the latest version of the Basel rules is finalized?
The banks’ answers to these questions are, broadly speaking: we don’t really know, but maybe later this year; and we just don’t know. Uncertainty over deposit costs, in particular, was expressed in banks’ cautious outlook for loan profits for 2024, leading to poor performance in bank stocks. The market is showing typical myopia here. Over time, a plateau of higher rates will make banks more profitable. It’s just that the timing of earnings is a little tricky during the transition.
However, listening carefully, several banks recognized the fact (much discussed by Unhedged) that low-end consumers – those with more debt than assets – have been hurt by rising rates. It is the better off who ensure the growth of the economy. Here is JPMorgan CEO Jamie Dimon:
Consumer customers are doing well. Unemployment is very low. House prices are rising. Stock prices are rising. The amount of income they need to pay off their debt is still pretty low, but the extra money from low-income people is running out – not running out, but normalizing, and you see credit normalizing a little bit . And of course, people with higher incomes always have more money and continue to spend it.
“Normalization” is a word used by several banks to describe the fact that defaults, write-offs and reserves have all increased. Here, for example, are the levels of past due balances in Bank of America’s credit card industry:
Note that we have surpassed pre-pandemic levels of late 2019 (the same is true if you look at delinquencies as a percentage of total loans).
Unhedged will not make the mistake of predicting whether problems at the bottom of the credit ladder portend weakening further up the ladder. Economic inflection points are impossible to predict. Rather, the point is that we can see, looking at the bottom end, that the economy is still dealing with the rate hike that began two years ago, and the injection of fiscal support that ‘did. The economy is generally strong and its biggest post-pandemic paradoxes have disappeared. But the situation remains dynamic. As Dimon points out, strong consumer spending was driven by wealthy consumers who benefited enormously from rising asset prices. This rally could be stalled now.
The banking earnings season has been boring so far. But don’t let that fool you. We still live in interesting times.
A good read
American supermarkets sell lots of small pieces of metal.
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