Inflation Numbers Likely to Speed Up Tapering Schedule

Team Transitory retired from the field of play last week and it could be like the grizzled veteran that saw the handwriting on the wall. We talk here about the upcoming CPI report for November, due on Friday, that we discuss in more detail below. It seems the November report is likely to contain some hot inflation numbers with the overall year-over-year printing at the highest level since 1982, while the year-over-year core (ex food and energy) is likely to print at the highest since 1991. Those are numbers that Fed Chair Powell no doubt had in hand and mind last week when he pivoted from dove to hawk on the inflation landscape.

We have written earlier about the Fed’s need to be seen as doing something, and with another month of steamy inflation numbers about to hit the tape the pivot to a faster tapering was probably the easiest decision to make, and so they are likely to do so next Wednesday. We still believe most of the inflationary impulse is supply driven and will subside as we move through 2022 but for now, the Fed needs to be seen as on the case, and that will likely be the case next week.

In our podcast this week we talk with Chad McKeithen and Geetika Bansal from our Duncan Williams unit to discuss investment ideas and strategies for year-end 2021 and into early 2022. The iTunes link can be found here and the Spotify here.



November CPI Likely to Force Fed’s Hand

As we move slowly through a slow data week towards Friday, the November CPI numbers loom on the horizon and the expectation is that they will provide the last bit of ammunition to accelerate the tapering schedule after next week’s FOMC meeting. Expectations are for a 0.7% month-over-month overall gain and 0.5% month-over-month core gain. That should send the overall year-over-year number to 6.8%, the highest since 1982. The year-over-year core rate is expected to move to 4.9%, the highest since 1991.

Source: Bloomberg

Those are the types of numbers that Fed Chair Powell probably had in hand as he pivoted last week from dove to hawk in testimony to the Senate Banking Committee.  While we have noted in pieces past that the fourth quarter was likely to be unkind to inflation numbers that is certainly proving to be the case, and it may be that they are too hot to just sit idly by and wait for the transitory impulses to fade.

From a math perspective, last year’s fourth quarter had small 0.1% and 0.2% monthly increases added to the calculation. Now those small gains are being dropped from the yearly calculations and replaced with 0.5%, 0.6%,  and 0.7% type increases and that is having the resulting upward impact to the yearly numbers.

That the math worked against the Fed’s “transitory” language is probably one reason Chair Powell decided to retire the term, even though the bulk of price increases are indeed transitory, but with ever-increasing yearly numbers it is hard to argue for continued patience. Thus, the path of least resistance is to be seen as doing something and that something is likely an acceleration of the tapering schedule such that it will be completed by spring, 2022.  If the inflation numbers continue to blaze red-hot expect the tightening campaign to commence by summer. For now, the market is expecting a total of 2.7 rate hikes in 2022. While the Fed was split on a single hike in their September forecast, that forecast will be updated next week and along with refreshed economic projections will be a key piece of economic news as we head into 2022.

Inflation Breakeven Rates Ease From Recent Highs

While the Fed may have been slow to fully join the battle against inflation, their recent shift has been noted by the market as investors expect the Fed to more fully engage with the inflationary threat. As the graph below shows, the TIPS Inflation Breakeven Rates have eased from highs set earlier in November when the Fed was still in full transitory mode.

Source: Bloomberg

The shift in tone from Powell last week before the Senate Banking Committee was noted by investors, and with a Fed more committed to combat a possible inflation threat the TIPS inflation breakeven rates have declined to levels last seen in early October. A Fed more committed against the inflation threat is also one reason longer-term Treasury yields have been rather docile of late.

The question becomes if inflation numbers continue to be hotter-than-expected, which push year-over-year numbers to multi-decade highs, will the nominal and real rate complex continue to remain sanguine? We think so. We think the true drivers of inflation are supply-driven and will abate slowly during the course of 2022. And with fiscal stimulus slowing, and a Fed moving from accommodative policies to tighter ones, economic growth should trend lower towards pre-pandemic levels providing another relief valve for the inflation threat. In summary, that is our outlook for 2022, an economy that slowly move towards pre-pandemic trends both in terms of GDP growth and inflation.

Agency Indications — FNMA / FHLMC Callable Rates

Maturity (yrs) 2 Year 3 Year 4 Year 5 Year 10 Year 15 Year
0.25 0.71 1.07 1.28 1.54 2.01 2.47
0.50 0.70 1.04 1.22 1.43 1.87 2.36
1.00 0.69 1.01 1.19 1.38 1.78 2.23
2.00 1.00 1.13 1.30 1.66 NA
3.00 1.26 1.60 NA
4.00 1.55 NA
5.00 1.51 NA
10.00 NA

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Published: 12/07/21 Author: Thomas R. Fitzgerald