Inflation/Deflation: What The Fed Balance Sheet, Yield Curve & Real Rates Are Telling Us

CLUB/EDGE post. Focus on Deflation Ahead.

» CLUB/EDGE client post JUNE 20th, 4:00 PM.

The preamble...
As I mentioned in my live trading room this morning, vacation days in the middle of the week are good for me to noodle around some macro thoughts.
Yesterday, I noodled (and posted about) my Summer Yield Call and Fall Oil Call - and how that intersects potentially with yen carry trade unwind into year end - all because I was doing my weekly INTERMARKET REVIEW write up and see a bearish monthly oil chart. Yes, that is how my brain works.

I then went in search of Inflation/Deflation narratives to dissect - given where I think they might land should I be proven correct with my projection of 10Y yield falling to 4.0% this summer and yield curve inverting further (-60% at least).

You know my saying:

Narratives FOLLOW Price.

So my job - for you - is to predict where PRICE is going and let the narratives catch up

With that, here goes a dump of macro thinking-out-loud before I get to my "revelation", because I want to try and address every argument on my way to the punchline.

Let's Start:

We Know: Inflation Compounds but its Rate of Change Matters More To Inflation Expectations.

With that, "Prices are Sticky" for all on Main Street. But those on Wall Street measure it's rate of change, and it has clearly been decelerating since CPI hit its high print of 9.1%  in June 2022.

So many machinations around whether Fed deserves a pat on the back for inflation falling as a result of aggressively hiking since Mar 2022, and/or giving credence to the theory that supply constraints during Covid caused this ‘transitory inflation’. And yet, actual prices have not reverted in any meaningful way after the supply disruptions resolved and rate hikes ended July 2023.

If anything (and as I argued July 2023), WAGE INFLATION DELAYED RECESSION, and prices themselves have become entrenched.

Now, I don't want to dive deep or argue my strong opinion for the biggest reason for inflation in this post. I have written about this argument before:

1. Massive fiscal deficit spending is inflationary.

2. Massive money printing by Fed to support treasury plumbing, equity markets and bank liquidity is inflationary.

3. Rate Hikes are inflationary

4. Wage Inflation is lagging but inflationary.

5. etc etc

Queue The Narrative Shift

I want to focus on why the narrative could switch soon from INFLATION to DEFLATION into year-end - despite continued fiscal spending/fiscal dominance firmly in play for the foreseeable future which is the most inflationary input we have.

Point #1: Fed IS Behind The Curve

We are likely not at risk of a second inflation wave until we get QE again. QE is what drove this inflation cycle in the first place post Covid shutdown - as is clearly illustrated from the FED BALANCE SHEET.

Further, Fed should have paused its QE back in March 2021 - when they failed to take the signal from the market when rising repo signaled they no longer needed the stimulus being provided. Instead Fed waited until June 2022, and even then it was minor, and repo helped to offset QT.

On top of that, banks parked large amounts of cash at the Fed earning 5% - instead of lending. Talk about having your cake and eating it too.

Needless to say, Fed/Treasury have been more than accommodative, and equity markets have rejoiced.

Interventions at key moments - October 2022, March 2023, November 2023 - have driven the animal spirits to bid up assets in general and equities in particular.

The AI fever going strong since May 2023 is the icing on the cake.

Point #1.5: Fed IS Political

Another consideration for delaying rate cuts is simple: it is a contentious election year.
And the the falling rate of change in inflation expectations gave Fed/Treasury some breathing room on their "inflation fight" - allowing them to pause rate hikes July 2023 and announce the pause November 1st 2023. Yellen Yahtzee made on that Quarterly Refunding Announcement November 1st, 2023 helped defend bond bulls by issuing more bills than longer-duration notes/bonds - bringing down yields, dollar and risk premia.

Talk about goldilocks! Now recession bets have dropped to only 5% from 28% just a year ago (BofA), and markets are making new all-time-highs seemingly every day!

Bulls are complacent - because Fed/Treasury is behind the curve AND political.

Fast forward eight months:
Global Central Banks are now cutting rates and the US 10Y2Y yield curve is inverting more deeply at a time the 10Y is more than 100 basis points below the Fed Funds Rate.

What is the bond market worried about? My bet:

1. Global interest rates are falling OR getting cut because of falling global credit

2. Global credit demand is falling from too-high and higher-for-longer rates.

Point #2: Jobs Matter

What took a decade of compounding inflation in the past took just three years post Covid. Bad for wage earners; good for asset holders.

Companies have been able to pass on higher prices as wage inflation has kept pace (on the aggregate) for lower income earners, while a massive wealth transfer has taken place for asset holders who are actively spending which keeps the economy from stalling. Add to that all the government hiring and spending, even if crowding out private investment, and we have a recipe for prices staying sticky but economy cooling as jobless claims intonate a turn higher and pull unemployment rate higher.

Why would unemployment rate turn higher?

1. Government is crowding out Private investment - nominal growth is clearly coming from govt expansion not industry.

2. AI is frightening companies to innovate or fall far behind - investment comes at a cost to stock buybacks and later headcount.

3. Immigration helped reduce the labor slack to keep wage inflation from spiraling - now supply-demand balance means lay-offs on first signs of stress.

4. Access to credit and refinancing corporate credit needs now mean a higher cost of capital - forcing compromises.

5. Global credit demand is falling with yields - which will trigger more belt-tightening/layoffs, competitive FX devaluation, bank lending contraction, bankruptcies, equity selling.

For now, there is no reason to worry/panic, but what if the benefits from the inflation narrative turn swiftly to a deflation narrative?

Point #3: Fed Balance Sheet Matters Most

Good news: CPI has fallen to 3.3% from a high of 9.1% - same time Fed Balance Sheet started to roll-over. Remember that chart from above?

And you thought rate of change in inflation expectations fell because Fed paused rate hikes. Ha!

My contention:

1. Inflation fell WITH the Fed's Balance Sheet

2. Markets stayed bid WITH Net Fed Liquidity

3. Spending stayed strong FROM wage inflation, and money making money on its money finding its way into every inflationary asset out there.

So which mattered more to inflation expectations? FED BALANCE SHEET

So instead of projecting rising real compounding inflation of things we use/consume every day, OR projecting potential Fed liquidity interventions should equities swoon, OR even anticipating the ‘forever-financing’ of unsustainable government debt-to-GDP and debt payments - all of which are inflationary ...
It seems we could just follow the FED BALANCE SHEET (over Fed Liquidity) to better smooth and time inflation/deflation.

And with that, we can potentially better project Fed policy on rate hikes/cuts.
And the Fed Balance Sheet has been falling in lock-step with CPI and inflation expectations.

Long Story Short: Fed Should Cut This Year

I know the arguments against inflation being tamed given real prices AND Fed cutting rates when Powell prefers consensus on his board, BUT it would not surprise me if FOMC starts talking "accommodation" sooner than the market has priced in - which is 1 cut "later this year, early next year" by Fed’s own admission.

As you can see from the charts below:

1. We may have witnessed peak inflation for this cycle after Fed/Treasury monetary policies back-stopped banks and markets

2. Given CPI topped in June 2022 at 9.1% and has fallen to 3.3% for  May 2024 coinciding with falling Fed Balance Sheet

3. The combination of Fed hiking rates to 5.5% with the decline in YoY CPI, have helped real rates to rise (see chart)

4. BOJ has recently hiked their rates post Fed-Pause, triggering a policy divergence that could further support rising US real rates.

5. Higher US real rates relative to other key partner countries will pressure USD higher. Cutting rates will result in dollar weakness.

6. Ironically, it is this exact sequence of events that happened in 2007 before the Great Financial Crisis and before the 1997-1998 Asian Financial Crisis.

I know we have "AI Tech Ecosystem" to save the markets AND it's an election year, but I can’t help wonder if both of these known distractions are camouflaging the risks of a fall in inflation expectations triggered by QT and a waning Fed Balance Sheet, at a time rising real rates are supportive of further disinflation - combined with BOJ policy divergence that could lift the USD and hurt Japan - all good enough reasons for Fed to cut rates sooner rather than later.

Final Word: A Fed Rate Cut Doesn't Negate Higher Yields for "Later"

As Geoffrey reminds,

"Large Issuance of debt NOT COVERED by taxes creates a large primary deficit.
A large US primary deficit makes nominal rates rise A LOT ...
Which would actually force Japan to sell UST, which itself would make rates rise...
So they let the interest rates differential play out, until it goes too far, and then they DUMP some UST.

Also good to keep in mind:

1. Higher US yields don't support a strong USD after the initial flight-to-safety trade.

2. Global interest rates that are falling because of falling global credit demand will require more competitive devaluation.

Geoffrey again:

Now, if we have a panic Gundlach-style, you could see Low USD with Plunging UST at the same time - that's your currency crisis."