Peaking Inflation?

Patrick O’Toole, Adam Ditkofsky and Pablo Martinez - 09/16/2022

Economic Data

Maybe. There was an expectation that this week’s U.S. consumer price index (CPI) report would show that the peak had passed. Not so fast. While it did peak for the all-in number, falling to 8.3% year/year from 8.5%, the core rate rose to 6.3%, from 5.9%. Yes, lower gasoline prices did help mitigate the rise, but rents – which account for roughly a quarter of CPI – are collected with a lag, and could result in continued upward pressure in the near term. The reaction to the new high in core inflation was swift, recalibrating the terminal Fed Funds rate higher. It’s now seen peaking at ~4.5%, with Canada’s futures markets showing a peaking in the Bank’s rate near 4.25%. All this can change higher or lower depending on how incoming inflation data and other reports play out. And yesterday’s U.S. retail sales report also surprised higher, although the core rate was flat on the month, meaning volumes were lower as prices were higher in the month. Unfortunately, July’s report was revised to ‑0.4%, from 0.0%. That’s led to some downward revisions to expected GDP in the current quarter, with the Atlanta Fed’s GDP Now expecting a gain of only 0.5%. At least that’s positive, after the two negative prints in the first two quarters of 2022.

In Canada, housing starts remain elevated, although there was a decline from July’s lofty level. Starts of new single homes posted a gain on the month, with the overall decline led by lower starts of multiples. Quebec, Nova Scotia and Alberta were the drivers of the decline as buyers responded to higher mortgage rates and have also seen home prices decline. The Canadian Real Estate Association (CREA) reduced its home price forecast in response to the 7.4% decline in home prices over the past six months. We also saw a larger than expected decline in wholesale trade sales in July, led lower by dips in personal goods, vehicles, and building materials. And a large build in inventories over the past year doesn’t bode well for growth in coming months.

Bond Market Reaction

There was an interesting reaction to the higher than expected core inflation report in the U.S. this week. 10‑year Treasury yields recalibrated 12 basis points (bps) higher, approaching the peaks seen in June. However, 30-year bond yields rose much less, ending the week up 5 bps. Canadian 10-year yields remain almost 0.5% below their June peak, however, despite the futures markets now expecting a higher peak rate from the Bank of Canada. The rise in short-term bond yields was notable, given higher expected terminal rates, leaving the 2-year Treasury yield and Canada’s 2-year yield near 15-year highs! It should be noted that, should the Fed hike its rate 0.75% next week as expected, the 3-month Treasury bill yield versus 10-year Treasury yield should soon become negative, a signal that a recession is coming next year (although it may already be underway).

The corporate bond market was surprisingly stable, despite the weakness in equity markets. The high yield sector, while suffering withdrawals in recent weeks, saw credit spreads only modestly higher, while the investment grade sector also held in well with strong demand for new issues continuing.

Stock Market Reaction

Global equity markets sold off largely in response to higher U.S. inflation than expected. In the US, Nasdaq was a laggard as valuations for high-growth tech declined. Adobe is worth noting with the announcement of a rather expensive $20 billion deal to buy design platform Figma, making heads turn due to the steep price being paid and an uncertain path to profitability. That’s certainly not what investors want to see as growth is slowing! Meanwhile, Europe has started to consider emergency plans to help households and business weather the energy crisis, notwithstanding a cap on excess revenues for electricity, windfall taxes on oil & gas businesses, nationalization of troubled gas suppliers, along with mandatory curbs on electricity consumption. That being said, the situation remains dire with further rate hikes to come from the European Central Bank (ECB) to continue the fight against inflation. In Asia, lockdowns in Chengdu (population of 20 million+) have started to ease, while more support being pledged for China’s property sector sparked a rally in developer stocks. None of the actions taken to support the economy have proven to be successful in a country where lockdowns are causing reverberations on global supply chains.

What to Watch Next Week

The U.S. Federal Reserve is expected to raise its rate by at least 0.75% next week. The U.S. will also release housing data and the leading index. In Canada, we’ll get the August inflation report and see retail sales from July. 

Disclaimer

1Patrick O’Toole is Senior Portfolio Manager, Global Fixed Income; Adam Ditkofsky is Senior Portfolio Manager, Global Fixed Income; and Pablo Martinez is Portfolio Manager, Global Fixed Income.

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