Since the beginning of this year, the market's "turnback run" to the Fed's interest rate cut expectations has largely come from the volatility of inflation. The more financial markets are concerned about secondary inflation, the more they can reduce the risk of secondary inflation, and vice versa. Just as the less expected a rate cut, the easier it is to trigger a rate cut. The next one or two inflation data will be crucial to expectations of a rate cut this year.
Our model calculates that the core CPI in this month's data has more than expected pressure, prompting investors to pay attention. However, in the long run, the volatility caused by CPI exceeding expectations can contribute to the tightening of financial conditions, which is precisely a "good thing".
In the baseline scenario, our model estimates that the risk of substantial secondary inflation is not high, except for the year-end tailing. Leading indicators of sub-items such as rents and wages are expected to slow down gradually. The risk factor is reflexive in financial conditions, and the more you expect a rate cut, the less likely it will be to cut it. The time window for monetary policy is in the third quarter, and if the rate cut trade starts too early, it may cause inflation to fall weaker than expected in the third quarter. The postponement to the end of the year will face the general election and the tail end of inflation, and the pressure will be even greater.
At the asset level, our financial liquidity and financial conditions model estimates show that U.S. equities need a pullback, and the window for interest rate cuts to open is in the third quarter. In terms of allocation, we recommend short-term debt first, long-term debt second, U.S. stocks and U.S. credit bonds after the correction before intervening, and bulk and gold are also significantly overdrawn. After the resumption of interest rate cut trading, from liquidity sensitivity to fundamental repair, it can be similar to the "outlet" of U.S. bonds → U.S. stocks → a large rotating asset since the beginning of this year.
Since the end of last year, the market's "turnback run" to the Fed's interest rate cut expectations has largely come from the volatility of inflation. It can be said that the next one or two inflation data will basically determine the pace of interest rate cuts during the year, after all, the current rate cuts are not in response to the deterioration of the economy ("The Fed's Threshold for Rate Cuts"). U.S. economic data such as employment, inflation and PMI continued to beat expectations in the first quarter, coupled with the sharp rise in commodity prices during the same period, which not only led to a decline in interest rate cut expectations, but even the sound of interest rate hikes reappeared amid secondary inflation concerns. However, in April, the reflexivity of higher interest rates gradually emerged, and the data on real estate, PMI, and non-farm payrolls slowed down one after another, and the expectation of interest rate cuts also rose again to two times this year (September and December). This phenomenon of "pushing" and swinging back and forth in both positive and negative directions is actually not surprising, and it is precisely the reflexive effect of the tightening of financial conditions that we mentioned earlier ("The pullback in US stocks helps the resumption of interest rate cut trade"). Therefore, from this perspective, the more financial markets are worried about secondary inflation, the more they can reduce the risk of secondary inflation, and vice versa; Just as the less expected a rate cut, the easier it is to trigger a rate cut.
Chart: From the end of last year to the present, much of the market's "turnback run" to Fed rate cut expectations has come from fluctuations in inflation data and inflation expectations
Source: Bloomberg, CICC Research
In the baseline scenario, our model estimates that the risk of large secondary inflation is not high, except for a slight tail at the end of the year, after all, high interest rates are enough to suppress demand, but the risk comes from prematurely anticipating the success of anti-inflation, as it has been since the beginning of the year. In addition, the time window is not wide, the third quarter is the window period for inflation to fall and the resumption of interest rate cut transactions, but if it is postponed again, not only the election factor, but also the end of the year, inflation may also be over, which will make the interest rate cut window no longer exist this year.
Short-term pressure: Suggests the risk of inflation exceeding expectations in April, but it is a good thing in the long run
According to our bottom-up quantitative CPI model, the core CPI in the United States for April (released at 8:30 p.m. on May 15) may exceed market expectations and remain unchanged from the previous month. We estimate that although the headline CPI of 0.32% m/m may be lower than expected and fall (previous value of 0.38%, consensus expectation of 0.4%), the core CPI may be flat at 0.36% m/m and significantly higher than market expectations (previous value of 0.36%, consensus expectation of 0.3%), with higher contributions from transportation, medical care and rent. The resilience of core inflation is likely to dispel last week's weaker-than-expected bullish optimism about interest rate cuts, which in turn will disrupt US Treasuries, US equities and gold, and we suggest investors to focus on them. However, as we have analyzed above, the volatility caused by the CPI exceeding expectations can lead to a tightening of financial conditions, which is a "good thing" in the long run, helping to curb inflation, and in turn can lead to the resumption of interest rate cut trading after the third quarter.
Chart: Based on our sub-model, the core CPI in April exceeded market expectations
Source: Bloomberg, Haver, CICC Research
On the other hand, if the CPI is unexpectedly lower than expected, such as the BLS making another adjustment to the CPI outside the model framework (such as the impact of the increase in the weight of single-family homes in the OER at the beginning of the year), although it may promote the expectation of interest rate cuts in the short term, and promote the risk on trading of lower US bond interest rates and a sharp rise in US stocks and gold, it will also make the demand and prices that have been partially suppressed revive again (for example, existing home sales fell in March due to higher mortgage rates), which will only lengthen the Fed's front. A repeat of last year's overly rapid decline in interest rates in the first quarter of this year, which led to higher-than-expected inflation in the first quarter of this year, will ultimately constrain the market to rebound, so we do not recommend getting too involved in such a rebound.
Base scenario: The risk of substantial secondary inflation is not high, and the third quarter is the key window period for interest rate cuts
In the baseline case, our model estimates that the risk of large secondary inflation is not high, except for a slight tail end at the end of the year, after all, high interest rates are enough to suppress demand. This is true when comparing the cost of financing and return on investment between the U.S. residential and corporate sectors, both in terms of mortgage rates (7.0%) and rental yields (6.7%), and in the corporate sector, in terms of average cost of borrowing (6.6%) and ROIC (5.9%). Therefore, as long as the current level of tight interest rates and financial conditions are maintained, we believe that inflation is also expected to gradually come under control over time. At present, the University of Michigan and the New York Fed Consumer Inflation Expectations Survey data show that consumers' inflation expectations for the next 1 year remain around 3%, so barring a large-scale unexpected supply shock, funding cost constraints and stable inflation expectations reduce the likelihood of secondary inflation or even hyperinflation in the 70s.
Chart: Mortgage rates in the residential sector (7.0%) are higher than rental yields (6.7%)
Source: Haver, CICC Research
Chart: The average cost of borrowing in the corporate sector (6.6%) is higher than the ROIC (5.9%)
Source: Federal Reserve, Haver, CICC Research
Chart: Data from the University of Michigan and the New York Fed Consumer Inflation Expectations Survey show that consumer inflation expectations remain around 3% over the next year
Source: Haver, Bloomberg, CICC Research
In terms of sub-items, the core factors constraining inflation, such as rents and labor prices, are expected to gradually slow down. 1) Leading indicators of rents suggest that the slowdown can continue into the beginning of Q3. According to leading indicators such as Zillow rental prices and BLS statistics on the quarter-on-quarter rent of new contracts, OER (equivalent rent), the largest weight sub-item in the CPI, will slow down significantly from the second quarter, and this slowdown will continue until the beginning of the third quarter. 2) Wage inflation and labor market tightness have eased more quickly. According to the NFIB Small Business Survey, the percentage of companies planning to increase hiring has reached its lowest level since 2016 (except for the extreme cases in early 2020). According to the NFIB and JOLTS surveys, the proportion of companies with still vacant positions and the vacant job rate have also returned to pre-pandemic levels. The easing of supply and demand in the labor market is reflected in the slowdown in wage growth, which was 0.2% month-on-month and 3.9% year-on-year in April, with room for further decline as the supply-demand balance continues.
Chart: According to leading indicators such as Zillow rental prices and BLS statistics new contract rents quarter-on-quarter, OER (equivalent rent) in the CPI, the largest weight sub-item in the CPI, will start to slow down significantly from the second quarter
Source: Haver, Bloomberg, CICC Research
Chart: NFIB Small Business Survey data shows that the percentage of companies planning to increase hiring has reached its lowest level since 2016
Source: Haver, CICC Research
Chart: The proportion of companies with still open positions and the rate of vacant positions have also returned to pre-pandemic levels
Source: Haver, CICC Research
Overall, our model estimates that the headline and core CPI fell back below 3% and 3.5% respectively in the third quarter, and may end slightly to 3.3% and 3.6% by the end of the year. This means that for the Fed, the third quarter of the inflation decline and the election sprint will be the key window for whether the policy can be adjusted, and the next one or two inflation data will affect this window.
Chart: Our model estimates that headline and core CPI will fall back to 3% and 3.5%, respectively by Q3
Bloomberg, CME, Haver, Zhongkin Research Department
Risk factors: supply shocks, or reflexivity of financial conditions; The more you expect a rate cut, the less likely it will be
There are two risks in the above-mentioned baseline path: one is supply-side shocks, which mainly include uncontrollable forces such as the risk of escalation of geopolitical situations, and policy supply constraints (such as targeted tariff barriers in the United States) caused by the approaching US election. The second is the reflexivity of financial conditions, such as the sharp decline in interest rates that rekindle residents' willingness to buy houses, the wealth effect brought about by the rise in U.S. stocks, the rise in commodity prices, etc., which will reduce the possibility of interest rate cuts, and postpone the timing of interest rate cuts, falling into the dilemma of "the more expected interest rate cuts, the more unable to cut interest rates".
► The wealth effect brought about by the rise in U.S. stocks will stimulate consumer demand. The S&P 500 index is highly correlated with household consumption and consumer sentiment year-on-year. The year-on-year growth rate of the S&P 500 Index has started a new round of growth since October 2023, from 8.3% to 20.8% in April this year, while the real consumer spending of US residents has increased from 2.1% to 3.1% year-on-year, and the University of Michigan Consumer Sentiment Index has increased from 6.5% to 20.8% year-on-year. On the contrary, the pullback in U.S. stocks will help suppress consumer demand and help cool inflation.
Chart: The annual return of the S&P 500 Index has risen from 8.3% to 20.8% in April 2023, while real consumer spending in the United States has risen from 2.1% to 3.1% year-on-year and the University of Michigan Consumer Sentiment Index has risen from 6.5% to 20.8% year-on-year
Source: Bloomberg, Haver, CICC Research
► U.S. stocks have not fallen enough, resulting in insufficient tightening of financial conditions. Financial conditions are made up of long-term interest rates, credit spreads, equity markets, and other items (The Fed's Threshold for Rate Cuts). The lack of asset correction has led to the lack of contraction in direct financing such as bond and equity issuances, as well as indirect financing secured by bonds and stocks, and the long time lag between the monetary cycle and the credit cycle, resulting in inflation resilience. In a certain sense, if it were not for the excessive decline of U.S. bonds to 3.8% at the end of last year, it would not have led to a sharp rebound in U.S. stocks at the beginning of the year, economic recovery and higher inflation.
Chart: The rise in U.S. equities and the pullback in interest rates have once again pushed financial conditions out of tight territory
Source: Bloomberg, CICC Research
► Rising commodities push up commodity inflation. Although commodity prices are not directly reflected in the financial conditions index, the logic of driving commodity prices and demand upturn, like U.S. stocks and U.S. credit, is premised on the start of a new economic cycle after interest rate cuts.
Therefore, if the current interest rate cut trade is restarted too soon, it may lead to a weaker-than-expected decline in inflation in the third quarter, and even the risk of secondary inflation, which in turn will cause monetary policy to miss this critical window. Facing the U.S. election in the fourth quarter, inflation itself will also have tail-end pressure due to a low base at the end of the year, and the time cost for the Fed to wait will be greater, and the potential financial risk pressure may also be higher. Therefore, this is one of the reasons why the Fed was cautious about the timing of future rate cuts at the May FOMC meeting ("Fed tightening in the short term is not a bad thing").
Asset Implications: The "price" of the resumption of interest rate cut trading is that financial conditions continue to tighten, and the redeployment time is in the third quarter
If the market trades interest rate cuts in advance again, the risk of secondary inflation will only be higher, which is why we have continued to emphasize that "it is not a bad thing for the Fed to tighten in the short term". The current rise in interest rate cut trading has led to a large distance between U.S. stocks and pressure levels. Based on the calculations of our two models, 1) financial liquidity model: According to the Fed's balance sheet reduction and deceleration, the consumption rate of goods-based reverse repo and the change in TGA, financial liquidity may usher in an inflection point in the second quarter of this year, causing pressure on U.S. stocks by about 7%, and the pressure will begin to ease in the third quarter. 2) Financial conditions model: If financial conditions return to the tightening range of 100, the U.S. stock market needs to pull back 10% to around 4,700 points, and U.S. credit spreads will widen by about 50bp. Therefore, the Fed will also need to maintain a tightening stance for some time to maintain a tightening posture in financial conditions.
Chart: Balance sheet reduction and deceleration will reduce the financial liquidity shock, and we estimate that the inflection point may occur in the second quarter
Source: Haver, CEIC, CICC Research
Chart: The U.S. stock market corrected 5-7% to around 4,700 points, U.S. credit spreads widened by about 50bp, and financial conditions could reach tightening territory
Source: Bloomberg, CICC Research
The next one or two inflation data will be particularly critical, and if it goes well, the next rate cut will be traded in the third quarter: 1) Financial conditions model: financial conditions are about 1 month ahead of inflation and growth surprise indices by about 1 month and 3 months, respectively, so the current tightening of financial conditions will reflect the suppression of demand and prices in the coming months. 2) Financial liquidity model: The Fed's balance sheet reduction has slowed down since June, which has played a hedging role in financial liquidity indicators. However, if the market rises instead of a correction in the second quarter, the corresponding pressure on the Fed's policy operation will be greater, and the layout time of the interest rate cut transaction needs to be further delayed.
Chart: Financial conditions outpace inflation and growth surprises by about 1 month and 3 months, respectively
Source: Bloomberg, CICC Research
In terms of allocation, we recommend short-term debt first, long-term debt second, U.S. stocks and U.S. credit bonds after the correction before intervening, and bulk and gold are also significantly overdrawn. After the resumption of interest rate cut trading, in addition to long-end U.S. bonds, assets that are more sensitive to the decline of U.S. bond interest rates, such as growth stocks, will be the first to benefit, and as the fundamentals improve, commodities are also expected to take over, similar to the "outlet" of assets that have been rotating since the beginning of this year, U.S. bonds →→ U.S. stocks ("How to grasp the "outlet" of rotating assets).
Chart: The asset "outlets" that have been rotating since the beginning of this year, from Bitcoin to Japanese stocks, to gold and copper, and then to the current Hong Kong stocks
Source: Bloomberg, CICC Research
At the current slight equilibrium between assets and expectations, one or two future inflation data will be crucial. Before the June FOMC meeting (early morning of June 13), the Fed can also see two inflation data for April (May 15) and May (June 12), so it is recommended to pay close attention.
Article source:
This article is excerpted from: "What is the risk of secondary inflation in the United States?" published on May 12, 2024? May 6~12, 2024》
刘刚，CFA 分析员 SAC 执证编号：S0080512030003 SFC CE Ref：AVH867
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