Inflation, a shelter story
Good morning. An absolutely epic swing in stocks yesterday — from a miserable opening after the hot consumer price index report to an exuberant close — left Unhedged as puzzled as everyone else. Short covering? Derivative hedges unwinding? Technical voodoo? We don’t know, but a big equity rally on a day when the futures market priced in another 25 basis points of Fed rate increases was not on our bingo card. If you have a theory, we’re all ears: email@example.com and firstname.lastname@example.org.
Inflation is still hot
Sure, they’re hot, but didn’t we know that already? That’s what Unhedged wondered as we read the latest CPI numbers, which showed falling headline numbers but a searing 0.6 per cent core inflation (ie, ex-food and energy) figure for September. It was a chunky miss for inflation analysts, who collectively had estimated 0.4 per cent core inflation.
Inflation remains a services story. Core services prices rose 0.8 per cent in the last month, above the 0.6 per cent August reading.
Services inflation is still mainly about shelter, the reliably hot (0.7 per cent in both August and September) category that makes up more than half of core services.
Goods disinflation is finally showing up. Falling shipping costs, commodity prices and swelling inventories offered hints this would happen, but any impact on CPI has been subtle. No longer:
Medical care (12 per cent of core services) rose unexpectedly, driven by the surging cost of eye appointments. Chances are this will fade. As we’ve written, next month’s inflation report will update the annual insurance data used to price medical services, flipping it to an inflation drag.
Transportation services (10 per cent of core services) shot up 1.9 per cent, well above August’s 0.5 per cent. It is hard to know how much this means. The category has been far more volatile, in both directions, since 2020:
Little in the report suggests inflation is about to spiral higher. To the contrary, goods deflation tacked on another drag. What’s happening in services is more debatable, but our view is that as services components such as medical care and transportation moderate, inflation will go from a story about services to one about shelter.
That raises the question, hotly debated on Thursday, of where shelter inflation is heading. Remember that CPI shelter is calculated from rental data. Doves argue that private rent indices have already turned over, but that CPI lags the rental market by nine months or so. That lag stems from CPI incorporating the full universe of new and existing leases, while private indices look only at new leases. If history repeats, CPI shelter (red line below) should soon start following market rents (grey and blue lines) down. From Nomura:
But there’s another way to look at it, as Adam Ozimek of the Economic Innovation Group pointed out to us. The chart above is of rent growth, but rent levels matter too. Ozimek shared this chart on Twitter showing the widening gulf between private market rents and CPI rents since the coronavirus pandemic:
In the long run, Ozimek has found, CPI rent levels catch up with private market rent levels, but shocks to market rents — like, say, a pandemic — are only reflected in CPI after a delay. He takes that to mean there is momentum now built into shelter CPI, even with rent growth slowing. Methodological issues make estimating how much momentum tricky.
Ozimek discourages panic, and Unhedged is not panicked. But we do fear inflation’s descent will be a long slog, and a story chiefly about shelter prices won’t change that. Thursday, in other words, gave the Fed few new reasons to slow down. (Ethan Wu)
Gilt market: problem solved?
The “mini” Budget mini-crisis may end with a whimper, not a bang, judging by Thursday’s markets. The pound is now stronger than the day before the budget announcement:
Thirty-year gilt yields are still much higher than they were before the announcement, but they fell Thursday:
And index-linked gilts — a particularly important asset in the current crisis, as pension funds dominate the market for them — only rose a little:
Bank of England governor Andrew Bailey can nod at these charts with satisfaction. His ultimatum to markets seems to have pushed pension-fund gilt sellers into the BoE’s bond-buying program and calmed the markets. The bank bought another £4.7bn in gilts yesterday, most of them linkers, and it has one more day of buying left (it says). But of course the relative calm on Thursday was not just the result of Bailey’s toughness. This helped, too:
Liz Truss was on Thursday locked in discussions on a major U-turn on the government’s “mini” Budget, prompting a market rally amid expectations that a £43bn package of unfunded tax cuts is unravelling.
Government insiders confirmed talks were taking place on whether to unwind parts of chancellor Kwasi Kwarteng’s fiscal statement, with speculation it could involve scrapping a planned £18bn corporation tax cut . . .[a] person close to the government discussions on the “mini” Budget said: “No decisions have been taken.”
An LDI pension manager told Unhedged that the mood was “quieter” but that he expected the market to follow the politics. He noted another factor, too. Speculators have taken advantage of the crisis to short long gilts and may want to cover soon, giving the market support over the next few days.
The biggest question is whether the pension funds as a group are now out of the woods: if they have sold enough liquid assets to meet margin calls, and have made a start towards resetting their portfolios for higher rates and rate volatility. I don’t know how to estimate how close the funds are, but if the liquidity crisis passes without permanently damaging balance sheets, the pensions could emerge in better shape than before, as Toby Nangle (the guy who saw this mess coming) has just written in Alphaville.
The real test for the gilt market will be on Monday, when the BoE is out of the market; markets on Fridays tend to act like Monday will never come. Fingers crossed.
One good read
Gideon Rachman talks to Alexander Gabuev about Vladimir Putin and nuclear weapons.