What’s going on guys? Had a slight issue publishing on Friday, but back to the usual schedule going forward!
Lend me your attention for the next few minutes.
In what is set out to be a heavy week of economic releases, particularly rate decisions from the big central banks, the Fed, BoE & BoJ, we look at the most recent CPI release and what that means for markets.
CPI Overshoots To 8.3% YoY
Yes, it’s the topic of the conversation once again! CPI in the U.S beat forecasts of 8.1%, finding some resting ground at 8.3%. Increases in the shelter, food, and medicare indexes were the largest of many contributors that pushed the CPI readings higher. Luckily, a 10.6% decline in the gasoline index offset the majority of the shelter and food-related increases.
The Weighting of Shelter Within CPI
In case you didn’t know, out of all the categories that combine to form the CPI reading, the weighted shelter takes up roughly 32% of the CPI print! That’s just under 1/3 of the whole reading, and from observing Chart 1 below we can see the sharp increase from July to August when the shelter CPI reading rose the most since 1991!
Commodities Shortage Effect on The Housing Market
Now, from as early as 2021, post Covid-19 recessions and amidst several global lockdowns in major commodity/goods exporting countries we saw U.S home buildings drop drastically and a surge in the number of construction backlogs due to shortages. Both on the commodity front foot and also on the transportation side where there was a clear reluctance within the U.S workforce. Particularly in the transportation of goods (truck drivers). Now, I am not pointing to this alone as the main contributor to elevated home prices but if we lay out the facts I’m sure you will see why there’s a direct link.
During the wake of the Covid crisis, lumber prices, copper prices, aluminium and all construction-related materials were extremely expensive to attain, (as shown in Chart 2).
What is the direct effect of elevated commodity prices?
Simple, delays and cancellations of new residential construction and commercial developments. So, the delays in construction projects only did one thing to the available supply/demand distribution; this lowered an already scarce housing market even further to the point where new home buyers’ demands couldn’t be met so home prices elevated to levels not seen in decades. To put this into context, the home price to median household income index shows the average cost of a house in the U.S relative to the households’ income.
Historically, an average house in the U.S. cost around 5 times the yearly household income. During the housing bubble of 2006, the ratio exceeded 7 - meaning that for a single household, it cost more than 7 times the average annual U.S household income. Pretty scary to see levels in the U.S above 2006 records by a country mile…
Bear in mind this ratio is heavily affected by interest rates within the economy; as a result when borrowing rates are relatively accommodative/cheap the demand and cost of homes increase due to the pent-up demand to purchase at low rates. As rates increase and yields on the U.S 10y & 30y increase, (the rate majority borrowing costs derive from), the affordability of homes decreases and so does the home price index.
Fed Rate Decision
With inflation still elevated despite hopes that we will see a decline following July’s stagnation, asset markets, in particular, the Nasdaq had a horrific close to the week.
Close to 6% wiped off tech stocks; I think it’s safe to say the equity bulls are back to hibernation until further notice.
Looking forward, the market is expecting to see either a 75bps or a 100bps hike this week, I see a 40% chance the Fed do a supersized 100bps hike; if you recall my previous note on CPI’s effect on rates, you would remember me specifically noting that if we see inflation come in above expectations we will see yield curve inversions between 2s&10s deepen further. If you didn’t get to read the note I’ve quoted my comments below for you.
“Now if CPI surprises us to the upside, well, just expect to see the 2s & 10s inversion deepen even more and long end yield curves to take a decline pricing in the aftermath of a deep recession."
— Joe, Market Macro Hub
For those who aren’t familiar with what an inversion in bond yields means, I’ve linked a previous note on the importance yields play within the economy.
Short-end yield curves are pricing in interest rates to peak at 4% in the U.S; so this is a forward look at investors’ expectations of the Fed hiking cycle.
As the Fed has said, the unfolding of economic releases will reveal to what extent they will have to hike until inflation is under control; that’s a long-winded journey for both the Fed and market participants. I recently caught up with a friend of mine who specialises in EM (emerging markets) and heard how bad some of these EM funds are down due to interest rate hikes. Instantly this put in perspective the ripple effect that this hiking cycle will have across every single market both developed and emerging. Countries like Sri Lanka recently defaulted early in May ‘22 for the first time in history; the reason rates play a crucial impact on EM countries is because a stronger dollar makes it more expensive to service debt repayments/infrastructure expenditure and usually triggers capital outflows as investors can now attain modest returns at lower levels of risk holding deposits in the U.S.
We won’t dive into EM, but that’s just a touch on the depth and weight the Fed interest decision has on the markets.
As always appreciate you for reading. Don’t just stop there, make sure to share this, doesn’t cost anything but means everything & subscribe if you haven’t already!
We’ll be back on Friday covering the rate decisions & a look into the BoJ
Joe