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August 18, 2022

Inflation’s slow decline shows the Fed’s challenge

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Julius Probst
Arnaud Lieugaut
Patrick Malm
Karl-Philip Nilsson
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US inflation is falling but only slowly

The drip-feed of price data continues to fuel the debate between those who think we have entered a new era of high inflation and “team transitory,” believers in a post-pandemic spike that will recede. The US consumer price index (CPI) for July, as reported by the US Bureau of Labor Statistics (BLS), showed a marked decline in the year-on-year rate, with the month-on-month change at zero.

How does this change the outlook for the rest of the year? Our chart below models how the CPI could evolve. Even if we have falling month-on-month inflation for the rest of 2022, inflation will come down only gradually and remain significantly above the Fed’s target. (That target is a 2 percent figure for the “core” personal consumption expenditures (PCE) price index, which excludes food and energy.)

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Covid-19 results in extended labour shock from sick workers

For labour markets, Covid-19 and its negative macroeconomic effects are far from over. Before the pandemic, the number of Americans at any given moment who were employed but not at work due to illness averaged about 1 million. 

Since early 2020, that number has jumped 50% to an average of 1.5 million people. The chart below shows the effect of the pandemic’s lingering labour supply shock, and that’s while the long-term negative effects of “long Covid” remain unknown.

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Canadian housing market seems to be finally turning

Observers of Canadian real estate have long wondered whether Vancouver and Toronto can sustain some of the world’s most expensive housing markets. This chart shows that average estimated sale prices for homes in the greater Vancouver and Toronto regions have been falling substantially in recent months. 

While this could be the start of a sustained turn, it’s worth bearing in mind that the average sale price is not the same as a general house price index. The drop could also reflect a compositional effect, showing lower-end real estate is dropping more quickly. However, that could suggest higher-priced houses aren’t selling as easily as before -- another indicator that market sentiment has changed.

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Chinese yuan likely has further to fall

The chart below shows the relationship between the yuan-USD exchange rate and the spread between Chinese and US interbank rates pushed forward by 80 days. With US interest rates surging, the spread has slid into negative territory in recent months. This indicator, combined with other Chinese data pointing to a significant economic slowdown, predicts further yuan depreciation ahead. 

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Chinese high yields are staying higher than Asian peers

For some time, Chinese spreads have surged amid expectations that the economy is heading into a severe slowdown -- and potentially even a housing crash that could spark a long recession. Interest rates on Chinese high-yield securities surged at the beginning of the year and continue to be extremely elevated compared to the high yield emerging market corporate plus index for Asia.

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Hong Kong is losing people

Hong Kong has seen a severe net migration outflow over the past year, and the total population has declined by about 300,000 from its peak. This is due to a combination of factors, such as boarder restrictions and a general economic slowdown. Hong Kong economy is likely facing further pain as a result of the hard currency peg to the USD. As the Fed hikes interest rates this year, the Hong Kong Monetary Authority must strictly follow suit to keep the exchange rate stable, damping economic activity.

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US corporate bonds are in a historic slump as the Fed hikes

The US corporate bond market is enduring its worst performance in recent history amid high inflation and rapidly rising interest rates. This chart plots the total return for every year since 1997, and shows the median yearly return was almost 7 percent. The bold line shows that 2022’s year-to-date total return is approaching minus 12 percent - without adjusting for inflation. It’s not a good market to be in as an investor.

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This time is different for corporate bonds in a tightening cycle

The following chart displays how US corporate bonds performed during every tightening cycle since the late 1990s. Strikingly, total performance was highly positive in previous cycles. There are reasons why this cycle, which began with the Fed’s first hike in March, is so different. 

Firstly, inflation in the 1990s and 2000s was very low; today, the US faces inflation of close to 10%, a much harder scenario for the Fed to navigate. Secondly, long-term rates were stable (and sometimes even declining) as the Fed hiked rates – see former Fed chair Ben Bernanke’s bond market conundrum.  This kept bond market returns more stable due to higher valuations. 

By contrast, the current hiking cycle has seen both short-term and long-term rates go up significantly, pushing bond prices down. Finally, the pace of the current tightening cycle is much speedier than its predecessors. These factors add up to a much more painful environment for corporate bonds than we have seen in the past.

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