Flying High

Tyler Durden's Photo
by Tyler Durden
Wednesday, Jun 21, 2023 - 02:00 PM

By Stefan Koopman, Senior Macro Strategist at Rabobank

As US airline passengers took to the skies in record post-Covid numbers over the Juneteenth weekend, with a total of 10.6 million passengers being screened at US airports, financial markets find themselves flying rather high as well. Equity valuations have reached lofty levels, propelled by robust economic performance that defies expectations in light of the Fed's higher and higher flight path. As we noted in last Friday’s Global Daily as well, the question looming large is whether central banks can engineer soft landings, whether we see some go-arounds, or whether some hard landings still lie ahead.

Many forward-looking indicators suggest we're on the brink of a turbulent ride, with inversely sloped yield curves and at times frightening business surveys. That being said, some of the recent US data indicate that a graceful descent is still very much a possibility as well. Real consumer and services sector spending is largely moving sideways, but activity in the construction and manufacturing sectors looks to be climbing out of the contractionary conditions that we’ve seen over the winter. It suggests both an improvement in the overall balance between aggregate supply and demand and a healthier sectoral composition. This is ultimately being reflected in a deceleration in inflation.

On Monday, the NAHB index rose to 55 in June, up from 50 in May, moving back into expansive territory for the first time in eleven months. Firming demand, a lack of existing inventory, and improving supply chain performance boost confidence and allow homebuilders to pull back on their sales incentives, such as mortgage rate buydowns. In line with the renewed optimism flagged by the survey, actual US housing starts rose a huge 21.7% month-on-month in May. This was the biggest jump in three decades. With a 1.63 million annualized rate the series also reached the highest level in over a year. It suggests that the housing market is rebounding after a tough year, making a housing recession and rising layoffs in the cyclical construction sector less likely, despite the steep rise in mortgage rates. In fact, according to the Atlanta Fed’s GDPNow estimate, which was upgraded yesterday to 1.9% annualized for the second quarter, residential investment may actually add to US GDP for the first time in two years.

The second data point that adds to the story of a deceleration in nominal growth, yet perhaps to the point of overshooting, was the Philly Fed’s non-manufacturing survey. The index fell to -16.6 from -16, with drops in new order intakes and sales and, crucially, a fall in both prices paid and received. The prices received index even dipped into negative territory, from 21.6 to -5.8, with, on balance, more firms reporting price cuts than price increases. It’s just one survey, of course, but it is one that swung from moderate inflation in May to outright deflation in June.

Bonds rallied yesterday, driven by a further bull flattening of the curve. The US’s 2s10s is now inching towards -100bp again, and Germany’s 2s10s declined to -71bp, just 2bp off its flattest ever yield. The fear of an overshoot is real, perhaps driven by comments from the ECB’s Schnabel and (many) other ECB speakers, who said that as long as core inflation remains high, the central bank should err on the side of doing too much rather than too little. This, and the absence of concrete economic support measures from China, leads to some cautious trading this week. Are we flying a bit too high? Can we really have a deceleration in nominal GDP growth without a deceleration in real activity growth?

In the UK, that looks to be very difficult. The UK 2s10s are now the most inverted since 2000, after this morning’s data showed that consumer price inflation remained stable at 8.7% in May. The reading once again topped the consensus forecast, which was for a slight deceleration to 8.4%. Core inflation rose to 7.1% in May versus 6.8% the month before, driven by another jump higher in the prices of services. This particular sub-index, which is explicitly mentioned in the Bank of England’s rate guidance due to its connection with wages, rose to 7.4% in May from 6.9% in April. The Bank of England had expected a decline to 6.8%.

Concerns that inflation is embedded in the British economy therefore persist. The big inflationary impulse is now well behind us, with falling prices for petrol and stabilizing food price inflation, but services inflation momentum is still building instead of weakening. The ONS notes that, for instance, the cost of airfares rose by more than a year ago and is at a higher level than usual for May. There were also notably higher prices for services such as live music events and computer games – which have little to do with last year’s original inflationary impulses.

The good news is that there were some pronounced declines in the PPIs, with the input PPI falling to 0.5% y/y from 4.2% y/y and the output PPI falling to 2.9% y/y from 5.2% y/y – again showing that the original inflationary impulse is fading sharply. So the part of inflation that was supposed to come down quickly, is now coming down, but the initial impulse is still propagating through the economy and hardly shows any signs of letting up. This is a worrying development.

The Bank of England meets tomorrow, and we now have three data points that could prompt a more hawkish reaction than a straightforward 25bp increase to 4.75%. The April CPI, the May CPI and the April labour market report were all ‘hot’. It means that a 50bp rate increase will surely be discussed. Traders attach a 25% probability of such a 50bp increment, while pricing a peak rate of nearly 6% by December. This is putting pressure on gilt markets today, with the two year’s yield up 10bp to 5.02% at the time of writing, and this pressure partially spills over to euro and dollar rate markets.

That being said, consumer and business inflation expectations have been receding from their recent peaks, supermarkets have started to cut prices, and the reduced energy price cap means that households will pay less for their bills from summer. We therefore still favor a 25bp hike over a 50bp hike, assuming that the MPC places some weight on these forward-looking indicators too. However, the higher you fly, the harder it is to feel confident when faced with challenging conditions…