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Powell Has Wall Street Buying View That Inflation Won’t Last

Federal Reserve Chairman Jerome Powell and his colleagues appear to be winning over investors with the argument that the current surge in consumer prices won’t last.

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Federal Reserve Chairman Jerome Powell and his colleagues appear to be winning over investors with the argument that the current surge in consumer prices won’t last.

When news broke that U.S. inflation climbed to 5% in May for the first time since 2008, yields on the key 10-year Treasury note moved in the opposite direction — falling to a three-month low of 1.43% on Thursday, before rising back up a bit early Friday. And while bond-market gauges of expected inflation edged upward, they remained well short of this year’s high reached in May.

That sanguine reaction is probably welcome news for Fed officials ahead of a June 15-16 interest-rate meeting – and it was bolstered Friday when a closely watched household survey showed that consumer expectations of inflation are declining too.

“Inflationary psychology takes some time to develop”

…said Richard Curtin, director of the University of Michigan survey. “It’s not an instant response among consumers.”

The Fed is widely expected to stick with an ultra-easy monetary stance next week, in pursuit of the twin goals of maximum employment and 2% average inflation. And they’ve been playing down risks that their policy could lead to a big and lasting overshoot on prices.

U.S. central bankers have been hammering home the message that higher inflation will mostly be transitory, the result of temporary bottlenecks as the economy reopens and low readings a year ago when it shut down.

‘Getting Comfortable’

“The best thing the Fed has done, the most effective, is that they stayed consistent around the transitory narrative,” said Peter Yi, director of short-duration fixed income and head of credit research at Northern Trust Asset Management, which oversees roughly $1 trillion.

Buttressing the Fed’s view, price increases in May were largely driven by categories where supply or demand has been skewed by the economy’s reopening, from used vehicles and household furnishings to airfares and apparel.

“A lot of the components that rose were the transitory ones,” said Yi. “More people in the market are now getting comfortable looking past these things.”

In a report to clients after the May data came out, JPMorgan Chase & Co. economist Daniel Silver agreed that the drivers of higher inflation are still mostly temporary — but added that “there is some firming taking place away from these factors as well,” pointing in particular to increases in rents.

Billionaire investor Stan Druckenmiller said the Fed’s easy-money measures have lulled investors into a false sense of security and distorted asset prices. “The market is not speaking right now,” Druckenmiller told CNBC television in an email Thursday.

In discussing the outlook for inflation, Fed officials have stressed the importance of expectations: If people believe that prices are headed sharply higher, they act in ways that help bring that about. So the absence of financial-market fears of a big run-up in prices is undoubtedly comforting.

But only up to a point. Policy makers –- perhaps especially Vice Chairman Richard Clarida — are well aware that the bond market does not give a completely clear reading of expectations, even among investors. It can be muddied by trader positioning, liquidity and other issues.

Flood of Cash

Indeed, financial strategists say bond yields have declined in recent days partly because of short-covering by investors who had previously bet on a move in the opposite direction.

The sheer flood of cash coming into the money markets — a fact that’s been highlighted by unprecedented usage of the Fed’s reverse repurchase agreement facility — is also a factor potentially supporting demand for Treasuries. Even at these levels, U.S. government debt offers more yield than many alternatives, including sovereign bonds in Japan and Europe.

Clarida, who served as global strategic adviser at Pacific Investment Management Co. before joining the Fed, is a self-declared “big fan” of a new index of common inflation expectations developed by central bank staff.

The index comprises 21 different measures of inflation expectations, including some drawn from the bond market, and is published quarterly. Clarida said last month that the index was in line with the Fed’s goal of an average inflation rate of 2%.

Unlikely, Not Impossible

Randal Quarles, the Fed’s other vice chairman, has said that he puts more weight on consumer surveys of inflation expectations than on readings from the bond market.

“Ultimately what drives inflation is peoples’ expectations about what they’re going to need in the way of wages,” Quarles told a Brookings Institution webinar on May 26. “Those are imperfectly measured, obviously, but better measured by surveys rather than market-based measures.”

The latest University of Michigan survey of consumer inflation expectations, published Friday, brought encouraging news for Fed officials. Respondents said they expected inflation to average 4% in the coming 12 months — still high by the standards of recent decades, but down from 4.6% a month earlier. Predictions for inflation in subsequent years also declined.

So far it seems unlikely that an inflationary psychology will develop, Curtin said. “But we can’t dismiss that issue out of hand.”

Finance

Tech Stocks Power Market to Record on All-Clear From Treasuries

For months, the threat of inflation grounded the tech stocks that drove the post-pandemic rebound. And yet, when data this week showed the threat is real, the Faangs took off.

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For months, the threat of inflation grounded the tech stocks that drove the post-pandemic rebound. And yet, when data this week showed the threat is real, the Faangs took off.

Investors in the tech megacaps can thank the bond market, where an epic change in sentiment sent 10-year yields tumbling the most in a year even after data showed inflation accelerated at the fastest rate since 2008 — normally a recipe for a spike in rates and trouble for stocks with high valuations. Instead, the Nasdaq 100 jumped 1.7% over the five days for a fourth straight weekly gain. The yield drop took the shine off value stocks, with banks slumping 2.4% in the week.

The signal from the bond market — that inflation isn’t a threat because the Federal Reserve is hellbent on keeping rates near zero — sets up a “great recipe for risk assets,” according to BNY Mellon Investment Management’s chief strategist Alicia Levine.

“The Fed has convinced everybody that they’re going to roll with it,” Levine told Bloomberg TV and Radio on Friday. “A mild inflationary environment is actually great for equities, it’s great for businesses, it’s great for wages and you don’t have a Fed that’s going to come and kill it all. So you’ve got cyclicals going and you’ll have tech going here.”

The Nasdaq 100 had languished as rising inflation was perceived as making tech shares’ already-stretched valuations impossible to justify. While investors rotated into value stocks for a while, the market’s loss of its heavyweight leader kept indexes in a rut since March.

The dam broke Thursday after the consumer-price reading came and went without market histrionics. The S&P 500 rallied to its first all-time high since early May and the Faang block climbed 0.6% in the week. The Russell 1000 Growth Index outperformed its value counterpart by 2.4 percentage points.

“The continuation of quantitative easing, the continuation of low rates is providing support to market multiples and perhaps to earnings”

Amazon.com Inc. jumped more than 4%, Twitter Inc. rallied 2.5% and Alphabet climbed 1.5% in the week. Meme stocks that captured much of the period’s headlines faltered along with Bitcoin.

Investors took solace from the nature of the rise in inflation even though it exceeded estimates, a third of the surge came from a jump in used vehicle prices, with airfare and hotels also rising — categories in stark demand as the economy reopens. Those price pressures are the type the Fed has been warning won’t be permanent.

And the central bank’s calculus is unlikely to change at next week’s meeting, meaning risk assets may continue their rebound. Policy makers are widely expected to stick to their ultra-easy monetary and downplay any risks from inflation. The bond market reflects as much, with traders closing out bearish positions en masse while trimming bets on Fed hikes.

“The continuation of quantitative easing, the continuation of low rates is providing support to market multiples and perhaps to earnings,” said Rob Haworth, senior investment strategist at U.S. Bank Wealth Management. “That’s supportive for stocks.”

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Inflation scare? Look at this chart before freaking out

Breakdown of price rises not in line with enduring inflation surge, says UniCredit’s Vernazza

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Inflation is on the rise in America, but if price pressures were likely to persist, contrary to the Federal Reserve’s expectations, the data would be painting a different picture, one economist argued Friday.

In a note to clients, Daniel Vernazza, chief international economist at UniCredit Bank, highlighted the complicated but interesting facts below:

“Since higher inflation is largely explained by the reopening of the economy and supply shortages, it’s likely to prove temporary as the direct effects of the pandemic fade and supply adjusts to meet demand.”

The chart plots the change in prices (vertical axis) against the change in spending (horizontal axis) relative to pre-pandemic levels in February 2020, by industry. It uses the personal-consumption expenditures deflator instead of the consumer-price index because PCE is the Fed’s preferred measure of inflation and to make better comparisons with spending data.

It shows that most items have moved backward and forward along the horizontal axis, implying that prices have shown little sensitivity to changes in demand, Vernazza explained. And for service sectors hit particuarly hard by the pandemic, including airfares and accommodation, the reopening of the econony has led to only a partial recovery of prices, which are still not back to pre-pandemic levels.

It’s a somewhat different story for car rentals, where acute supply shortages have caused prices to surge, while spending in the sector remains well below pre-pandemic levels because of limited supply, he said. For used cars, the combination of a switch away from public transport by commuters and a global shortage of semiconductors for new cars has pushed up both demand and prices.

What’s important to note, Vernazza said, is that since higher inflation is largely explained by the reopening of the economy and supply shortages, it’s likely to prove temporary as the direct effects of the pandemic fade and supply adjusts to meet demand.

But what would a more enduring inflation threat look like?

In that case, most of the items would occupy the upper-right quadrant of the chart, reflecting what economists refer to as “demand-pull inflation,” Vernazza said. To date, “this is clearly not the case,” the economist wrote.

Higher inflation is typically seen as bad news for bonds, eroding the value of the interest payments delivered to holders. Stocks rallied Thursday, with the S&P 500 SPX, +0.19% edging to a record close on Thursday, while the Dow Jones Industrial Average DJIA, +0.04% remains not far off its all-time high and rallying tech shares, which are more sensitive to interest rates, pushed the Nasdaq Composite COMP, +0.35% higher.

The Federal Reserve holds a policy meeting next week. While Fed officials have largely stuck to their view that inflation pressures will prove “transitory,” several have also said it’s time to begin thinking about when it would be appropriate to discuss pulling back on asset purchases at the center of its extraordinary monetary policy efforts to support the economy and heal the labor market.

And some economists caution that signs of inflationary pressures in more cyclical segments of the economy are beginning to emerge.

“Both rent and owners’ equivalent rent have staged a clear turnaround over recent months, and food-away-from-home prices surged by 0.6%,” said Michael Pearce, senior U.S. economist at Capital Economics, in a note. “It is no coincidence that rents and restaurant prices are rising more rapidly when wage growth is also accelerating.”

Pearce said a continued surge in job openings shows that worker shortages “are real and intensifying.”

“The recent strength of inflation and signs of labor shortages could prompt a handful of hawkish regional Fed presidents to bring forward their projections for rate increases and strengthen calls for tapering asset purchases sooner rather than later at next week’s FOMC meeting,” he wrote. “But we suspect the majority on the committee will stick to the ‘largely transitory’ language and instead emphasize the yawning shortfall in employment from pre-pandemic levels.”

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Is this the Manchin rally? Bonds are rising and stocks at record high as spending expectations wane

World leaders from the Group of Seven are meeting in Cornwall, England, discussing plans for a global corporate minimum tax and to distribute COVID-19 vaccines, among other topics.

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You wouldn’t expect stocks and bonds to rise after a hotter-than-forecast inflation reading in a market that has been obsessed with the I-word, yet that’s what happened on Thursday.

With consumer prices excluding food and energy shooting up 3.8% year-over-year in May — the hottest reading since 1992 — the yield on the 10-year Treasury slipped 3 basis points, down to 1.46%. Yields move in the opposite direction to prices. The S&P 500 SPX, 0.12% finished at a record high, and the technology heavy Nasdaq Composite COMP, 0.15% has climbed four of the last five days.

Sure, there was some talk that what drove the consumer-price index higher were transitory items, like used-car prices, which should come back to reality once the semiconductor shortage is resolved, making new cars more easily obtainable. But a look at the Atlanta Federal Reserve’s breakdown doesn’t lend support to that interpretation. The sticky price CPI — that is, the cost of goods and services that are typically slow to change in price — shot up an annualized 4.5% in May, after jumping 5.5% in April. There haven’t been two back-to-back readings this strong in 30 years.

Kevin Muir, a former institutional equity derivatives trader turned blogger, called it the Manchin rally on his Macro Tourist blog. Sen. Joe Manchin’s unwillingness to go for a Democrats-only infrastructure package — on Tuesday, he said he wasn’t even thinking about using what’s called reconciliation, which would allow for passage without any Republicans voting — is tempering fiscal spending, as well as tax, expectations.

The West Virginia Democrat is part of a bipartisan group, which also includes another moderate Democrat, Sen. Kyrsten Sinema of Arizona, that is calling for $1.2 trillion in infrastructure spending over eight years, without tax increases apart from indexing federal gas taxes to inflation. That is well short of the $1.7 trillion President Joe Biden is seeking, who also calls for increased corporate taxes. Biden separately is calling for $1.8 trillion in investments in what he calls the American Families Plan, in areas like child care and healthcare, to be paid for by increased taxes on the wealthy.

“The firm rejection over the past several weeks of many of Biden’s tax increases,” added Joe Lieber, managing director at Eurasia Group, “is also likely to shrink a bill’s size to the bottom end of our base case $2-$3 trillion range, and increase reliance on deficit financing such a package.”

Reading the tea leaves in Washington is more art than science, but it is also notable this week that former Vice President Al Gore lobbied Biden to keep climate investments in the infrastructure package, a sign of the growing feeling that the president would accept a less sweeping deal.

“The 10-year yield continued to drop on Friday, sliding down to 1.434. U.S. stock futures ES00, 0.18% NQ00, 0.03% inched higher.”

World leaders from the Group of Seven are meeting in Cornwall, England, discussing plans for a global corporate minimum tax and to distribute COVID-19 vaccines, among other topics.

The University of Michigan’s consumer sentiment index for June highlights an otherwise quiet day on the economics front.

Tesla TSLA, -1.33% Chief Executive Elon Musk took a break on Thursday from his cryptocurrency tweeting to unveil the Model S Plaid, a high-performance version of the sedan.

Cinema chain operator AMC Entertainment AMC, 0.09% had its credit rating upgraded by S&P, due to the company raising cash by selling equity to meme-stock-obsessed investors. S&P nonetheless rates the chain as seven tiers below investment grade.

Chewy CHWY, -2.46%, the online pet-products retailer, beat expectations on earnings but also flagged the impact of labor shortages.

Vertex Pharmaceuticals VRTX, -8.74% fell 14% in premarket trade, as the biotech stopped development of a drug for a rare genetic disease, in what may be good news for Arrowhead Pharmaceuticals ARWR, 6.06%, which is working on a drug treating the same condition. Arrowhead shares rose 4%.

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