How Long Before Rising Inflation Leads To A Recession: Deutsche Answers

While inverse vol funds were the immediate catalyst for the February 5 market crash, the market's recent jittery behavior has coincided, and often been blamed on, the recent uptick in inflation. That said, as Deutsche Bank's Binky Chadha writes, whether this was cause and effect is debatable. Nonetheless, late in the business cycle with a tight labor market, "strong coordinated growth", a lower dollar, higher oil prices and a fading of one off factors, all point to inflation moving up.

As a result, two key questions have emerged: What does higher inflation mean for equities? And how long until higher inflation translates into a recession.

Here, Deutsche Bank makes some preliminary observations. First, and conceptually, higher inflation is ambiguous.

From a pricing vs cost perspective, whether higher inflation leads to higher or lower margins depends on the relative strengths of price vs wage and other input cost inflation. It depends on the relative importance of variable vs fixed costs. And on the extent to which corporates can increase productivity in response to cost pressures. It is notable that while markets seem to have been surprised by the recent uptick in wage inflation, corporates have been noting it for at least a year. Finally, inflation does not occur in a vacuum. The drivers of higher inflation matter and when it reflects strong growth, it implies not only higher sales but operating leverage from fixed costs can raise margins and amplify the impact on earnings.

In other words, inflation in itself is not a death sentence to bull markets. What is just as important is overall economic growth (rising inflation is benign if overall economic growth is higher), as well as the impact of inflation on profit margins - i.e. the ability to pass inflation through to the end consumer - and most importantly, how the Fed reacts to inflation, or namely does the Fed think it is behind the curve.

Ultimately, it all boils down to whether future inflation will be higher (or much higher) than currently.

Here one of the reasons why the Fed has been gingerly hiking rates at a glacial pace in recent years is that persistent inflationary pressures have largely been absent during this bull market cycle. However, recent data points indicate that any inflation surprises over the coming months will most likely be to the “upside.” And, judging by its quotes, the Fed is also taking noticing as well, potentially realizing that it is behind the curve, as highlighted by the change of tone in the quotes below:

  • Nov 1, 2017: "…the Committee is monitoring inflation developments closely"
  • Dec 13, 2017: "…the Committee is monitoring inflation developments closely."
  • Jan 31, 2018: "The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal."

Making matters worse, while the Fed has raised rates 4 times since Sept. 2016, increasing the discount rate by 1.00%, the 2Y Tsy has increased by 1.70% over the same period, suggesting that bond vigilantes see the Fed as behind the curve, literally.

Furthermore, as Investec points out in a recent note, although both headline and core inflation appear tame – a key leading indicator from the New York Fed, the Underlying Inflation Gauge (UIG), is pointing towards increased risks ahead, having hit 3.00% in January, up from 2.94% in December and the highest level since 2007.

Furthermore, as Investec adds, the UIG has proven especially useful in detecting turning points in inflation trends, and has shown high forecast accuracy when compared with core inflation measures. As shown in the chart below, the UIG has been indicating far higher levels of inflationary pressure relative to Core CPI since over the past year.

The divergence between the core CPI and UIG is notable, and reached a differential in excess of 1% in recent months. Based on historical patterns, such a wide divergence has been followed by increasing pressures in official inflation statistics, prompting the Federal Reserve to become more aggressive in their actions.

And while one can argue whether higher inflation is bad, one thing is guaranteed: rising interest rates are the nemesis of an aging bull market. Nothing has killed more bull markets than a deteriorating monetary climate with a relentless uptrend in interest rates; in fact, as we have shown previously, virtually every single Fed tightening cycle has always ended with a recession or some "event."

Once started down the track of tightening, the conclusion seems all but inevitable. Out of 11 past tightening cycles, nine have resulted in a recession while only two created a soft landing that allowed the Fed to ease and avoid a recession.

Here another observation from the historical record: the Fed has a dismal track record of slowing the economy and at the same time avoiding a full blown recession. As investec ominously points out, "while each cycle has its own unique characteristics, the odds are not favorable that the current Fed tightening cycle is going to end happily for investors."

* * *

Which brings us back to the key question: how long before rising inflation results in a recession?

For the answer, we go back to Deutsche Bank, which looks at the role inflation has a leading indicator of recession. Specifically, the German bank asks "Is the inflection in inflation a leading indicator of the end of the cycle? How
long is the lead?"
It answer: On average 3 years... but the Fed’s reaction is key. Here are the details:

If the recent uptick marks the typical mid-to late-cycle inflection up in inflation, how long after did the next recession typically occur? On average 3 years, which would put it in late 2020. But the timing is likely determined critically by the Fed’s reaction.

Historically, a Fed rate-hiking cycle preceded most recessions since World War II, with recessions occurring only after the Fed moved rates into contractionary territory. Arguably the Fed did this only after it was convinced the economy was overheating and it continued hiking until the economy slowed sufficiently or went into recession.

At the current juncture, core inflation has remained below the Fed’s target of 2% for the last 10 years and several Fed officials have argued for symmetry in inflation outcomes around the target, i.e., to tolerate inflation above 2%. It is thus likely that the Fed will welcome the rise in inflation for now and simply stick to its current guidance, possibly moving it up modestly. It also means that if indeed the Fed intends on running the economy hot, equity investors may want to consider jogging quietly for the exits, especially before the vol-targeting, inverse vol, Risk parities, CTAs and the rest of the systematic funds decide to make another sprint for it.


LetThemEatRand Sat, 02/24/2018 - 20:59 Permalink

"Late in the business cycle with a tight labor market, 'strong coordinated growth', a lower dollar, higher oil prices and a fading of one off factors, all point to inflation moving up."

Am I the only one who sees the ridiculousness of the premise of this article?   There is not a "tight labor market," unless by "tight" the author means that people have not yet adjusted to accepting less than they can live on in many markets to take a job because offshoring has lowered wages drastically.  There is not "strong coordinated growth," unless the author means growth of CEO benefit and compensation packages due to offshoring and free money from the Fed.

The goose that laid the golden egg for these banker assholes has been seriously wounded.  


AmarUtu LetThemEatRand Sat, 02/24/2018 - 21:17 Permalink

It will end when those who get rich from drinking the blood of the poor drink their last drop.

And thats when the poor working class can no longer pay back their debts.

They will prop this up with mass immigration tax slaves, it will last 2 generations then all bets are off because the numbers will never calculate again, growth will become much like a cancer of unsustainable poverty and human suffering.

In reply to by LetThemEatRand

Oldwood LetThemEatRand Sat, 02/24/2018 - 22:16 Permalink

There are different labor markets and surely they are not all the same.

Had dinner with my wife's cousin, a chain grocery manager. He cannot hire store help for $40k a year and those employees he has refuse promotion because they don't want the stress of responsibility.

There is definitely a labor shortage if you actually want someone with a brain who will use it. Our reality is that there is a significant contingent who don't want a job and have found entitlement revenues that they can skim by on. The gap between those who WILL work and those that WON'T is growing.

This is why I sold my furniture business and have started a technology​ based woodworking machinery sales business.

Going into shops you see what they are dealing with, and it is NOT a problem of low wages unless you think $60k/yr is too low. Just getting people to reliably show up is a challenge, and to think is just too much to hope for. Selling technology into these businesses is not a hard sell. We can put machinery on the floor for 60k/yr that can transform a few zombies into a high production cabinet shop.

People are being lulled into a trap with borrowed and stolen money subsidizing a unsustainable system that pays people not to work.

Ultimately it will all fail, but meanwhile automation is the only lever for business to survive.

In reply to by LetThemEatRand

karenm Sat, 02/24/2018 - 21:11 Permalink

Because....tens of thousands of closed stores, half empty sports stadiums, and mass layoffs in every sector is "not a recession."



TheBigCluB Sat, 02/24/2018 - 21:12 Permalink

with just shy of 50 million in the invisible soup kitchen line called ebt, i would call what we are living presently as a full blown depression.

Yen Cross Sat, 02/24/2018 - 21:16 Permalink

  First> there was Dennis Gartman.

  Then there was Douche Bank, and Joe La Vorgna.

   Joe got fired BTW/

 If you're going to join the casino, do your homework first.

  Passive investing is a fucking farce! Cost averaging is a fucking farce!

Oldwood Yen Cross Sat, 02/24/2018 - 22:23 Permalink

Gambling is for gamblers, of which I am not.

What really pisses me off is that the gamblers who largely would have no casino without people actually making and servicing things, can burn the entire economy to the ground out of ignorance and greed, like an idiot ruler with his finger on the nuclear button, willing to melt the planet to make his point.

In reply to by Yen Cross

JPMorgan Sat, 02/24/2018 - 23:21 Permalink

Already there.

Consumer discretionary spending only has one way to go already being over extended on debt.

Public liquidity is running on a near empty tank.

Nelbev Sun, 02/25/2018 - 02:30 Permalink

Rising inflation and overheating economy are normal Fed choreographed excuses to raise rates, but this go round we have about $2 trillion in excess reserves parked/deposited at Fed earning a tad over 1.5% interest at fed funds target.  Market rates or rising, banks can buy higher yielding treasuries or make car loans, you can earn 3% arbitrage lock on some futures.  Fed has to raise rates playing catch up to prevent excess reserves from escaping dramatically increasing the money supply.  Inflation is just an excuse to raise interest fed pays on excess reserves less all hell breaks lose if those excess reserves enter money supply, could be beginning of vicious cycle of fed chasing market rates until next recession is apparent.

Ink Pusher Sun, 02/25/2018 - 08:45 Permalink

This proposed schedule is a fantasy fiduciary creation of the clowns at Douche Bank based upon their own flawed analytics and false representations.

The FED has already said they can't raise rates, It's a no brainer.

EX-Bronco-Fan Sun, 02/25/2018 - 12:11 Permalink

Deutsche bank can't even read their own tea leaves much less the global tea leaves. Did Deutsch bank tell you that when they collapse, they will bring down capital markets around the world?

wisehiney Sun, 02/25/2018 - 12:12 Permalink

Fed is in a real bind.

They hate with a passion to pay higher interest to those who will not play in their rigged casino.

What a great show!