The week ahead: US CPI and PPI set to soften
The Fed’s 50bp rate hike is behind us. Another 50 basis point hike is expected next month. April’s jobs report will do little to ease concerns about the “too tight” labor market. The drop in the the participation rate has been disappointing, which, together with the drop in productivity in the first quarter, raises questions about the economy’s non-inflationary speed limit.
One of the fascinating things about markets is that sometimes cause follows effect. It is an interesting way of expressing the observation that investors anticipate, update, future scenarios. The dollar was bought and fixed income sold on ideas that the Fed had taken a hawkish turn. The market now accepts that the Federal Reserve should bring its target Fed funds rate back to the range considered neutral before the end of the year. The upsides will be anticipated with the next 50bp upsides discounted for the next two meetings (June and July) and a strong bias for the same in September (~66%). The balance sheet will begin to contract next month at roughly the same rate it peaked in the 2017-19 experience before rising up to twice as fast ($95 billion).
The week ahead is important as it could be the first sign that peak inflation is near. For the first time since April 2020, headlines for consumer prices and producer prices are expected to have fallen year-over-year. Admittedly, this may not be a big move. By any measure, price pressures remain elevated, but direction matters.
This would be the first drop in the headline CPI since last August. Core CPI will also likely decline. Recall that after the March report, many economists suggested that this could be the high point. – Producer prices, both headline and core, are also expected to have eased slightly. In April 2021, they had increased by 1.0%.
The composition of inflation could also change. Used car prices generated a lot of discussion last year. Prices are falling, as Powell suggested when he drew attention a year ago to used car and lumber prices. The unusual rise in durable goods prices could stall. Housing costs can take over.
One of the most important developments last week was the surge in the swap market to set a final fed funds rate near 3.75%. Some, like renowned economist and former chief economist of the IMF, Kenneth Rogoff, believe that a considerably higher rate (5%) could be needed to break the price spiral. However, most observers believe that economic conditions will justify ending the tightening cycle by then. By the time the Fed pushes the funds rate into the 3.75% zone, the pockets of economic weakness, which are already showing below the surface, will likely have widened and deepened.
It’s not just the national economy either. Headwinds will emerge globally. Although the April PMI readings in Europe continue to show resilience, the deterioration in consumer and business confidence is alarming. German and French industrial production fell more than expected in March. National governments are reducing growth forecasts. The ECB has not moved. It continues to expand its balance sheet. The hawks are pushing for a rise in July and the swap market is taking the bait. We are less convinced that a consensus in this direction has crystallized among the members of the ECB. The Bank of England has warned that UK output could contract by 1% in the fourth quarter as the cost of living bites, with the ceiling on energy prices being raised a further 40% in October. The BOE sees the economy contracting by 0.25% in 2023.
Japan doesn’t release its Q1 22 GDP until May 18, but that it contracted won’t come as a surprise given the prolonged Covid and earthquake restrictions. This is old news in many ways. Perhaps more importantly, the recovery is already underway and will be helped by further stimulus. April’s preliminary composite PMI rose for a second month and, if confirmed (May 9), will be at a four-month high.
Arguably, Japan’s current account numbers for March, due May 12, will be remarkable. First, the first trade surplus in five months is expected. Admittedly, the trade balance, as we have noted, is not the driver of the current account surplus. Capital flows associated with past investments, such as interest, dividends, profits, royalties, advertising license fees, fuel Japan’s current account surplus.
Second, along with the current account report, Japan also reports portfolio capital flows. The MOF publishes weekly figures, but the monthly figures include a breakdown by country. Recall that the February report showed that Japanese investors had sold around 3.1 trillion yen (~$25 billion) of US sovereign bonds. Some observers have pointed to the Japanese selling of US Treasuries. Often the cost of coverage is quoted. The general flattening of the yield curve in the United States makes currency hedging more expensive and eats away at the rate advantage.
However, some Japanese life insurance companies like Sumitomo have recently indicated that they will increase holdings of uncovered bonds. Even more difficult for the narrative is the fact that the US Treasury’s report on international capital (TIC) suggests a more nuanced story. In fact, the TIC report showed that Japanese investors increased their holdings of US Treasuries by $3.2 billion in February.
Sometimes the two sets of data tell a similar story. MOF figures showed that Japanese investors sold around 143 billion yen (~$1.2 billion) in January. Data from TIC showed the liquidation of just under $1 billion. And it’s not that the TIC data is skewed in favor of lower sales by Japanese investors. In December 2021, for example, data from the TIC showed that Japanese holdings of US Treasuries fell by around $24.6 billion. MOF data showed that divestment accounted for half of that. More work needs to be done to understand the differences between two-stroke series.
Chinese policies are often difficult to understand from the outside. Its zero-Covid policy is a timely example. As the virus has mutated, it is less deadly even with Chinese vaccines, which are said to be less effective than those from Moderna and Pfizer. Extreme shutdowns are crushing the economy. Consider the composite PMI to be 42.7 and 37.2 for the official measure and the Caixin version, respectively. Such readings are consistent with an outright economic contraction.
China reports several data points for April that will draw attention. First, China’s reserves have probably fallen dramatically. This could be the biggest drop since November 2016, when they fell $69 billion. Data from the TIC shows that China has reduced its holdings of Treasuries in recent months by around $26 billion between December 2021 and February 2022. However, the main culprit will likely be valuation. The dollar value of its foreign currency holdings (non-US bonds) fell as the greenback appreciated significantly last month. The euro fell 4.7% and the pound sterling 4.3%. The Australian dollar depreciated 5.6% and the yen slipped 6.2%. In addition, bond prices fell in April.
Second, last month’s lending numbers will be released. Total lending soared 4.6 trillion yuan in March. This lifted the first quarter average by CNY 4 trillion, up about 17% from the first quarter 21 average and the CNY 2.6 trillion average for the whole of last year. Seasonal considerations and shutdowns warn that lending may have slowed to about half the pace in March.
Third, China’s trade balance is skewed by the demand squeeze due to the Covid response. Imports likely fell for the second consecutive month in April year-over-year. Exports were erratic and likely slowed from the 14.7% year-over-year pace seen in March. China’s trade surplus averaged $54.3 billion in the first quarter, compared with an average of about $36.2 billion in the January-March period last year.
China’s monthly trade surplus averaged $56.4 billion last year. It has practically doubled since 2018 (average monthly surplus of $29.25 billion). When the yuan appreciates against the dollar, it makes sense for companies to quickly convert their hard-currency revenue into the yuan. But that’s not the case right now, and companies don’t need to be rushed. Reports suggest the Biden administration is debating internally whether to remove some of the tariffs on Chinese goods, not as a boon for Beijing but to dampen US inflation.
The United States applies an average additional tariff of 16% on just over $500 billion of Chinese goods. However, the impact on inflation measured in the United States seems weak. A recent report by the Peterson Institute for International Economics calculated that a two percentage point reduction in the average tariff on the $2.8 trillion in goods imported by the United States could reduce just over one percentage point percentage of GDP. It’s unlikely to be a linear process, but imports from China account for about 18% of US imports. A two percentage point reduction in tariffs on Chinese goods could be worth around 0.2% reduction in measured inflation.
Fourth, China will release the April CPI and PPI. It was common in some circles last year to attribute the rise in the US CPI to the Chinese PPI, but that never made much sense to us. And frankly, the data didn’t seem to support the thesis. It looks even fancier now. China’s year-on-year PPI is expected to have fallen for the sixth consecutive month. It peaked last October at 13.5% and was at 8.3% in March. Economists (median forecast of the Bloomberg survey) expect a drop to 7.5%. China’s CPI is expected to have edged up to 1.9% from 1.5% in March. It increased by 1.5% in 2021. Food price deflation is easing and non-food prices increased slightly in February and March. One implication is that price pressures do not preclude additional measures to support the economy.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.