Under Pressure
Last week HAI featured a very notable comment from economist Mohamad El-Erian. This week let’s start there. Following the latest FOMC meeting and Powell presser El-Erian said, “It would not surprise me if future economic history books were to look back at the last week in central banking as marking a move away from strict inflation targeting by the world’s most influential central banks.”
This week we received further confirmation that, indeed, we do have an inflation problem—and by extension a monetary policy problem. It was another bad week for Jay Powell. In fact, if HAI were to select a theme song for the week, it would undoubtably be the all-time hit collaboration between rock band Queen and legend David Bowie released in October of 1981—Under Pressure.
March CPI inflation data out on Wednesday came in piping hot. It was the third consecutive month in which inflation data has surprised to the upside, and it threw a major wrench in Jay Powell’s plan for rate cuts starting as early as June. As JPMorgan’s Chief Global Strategist David Kelly said following the CPI release, “The sound you heard there was the door slamming on a June rate cut.”
The CPI data for our 37th straight month of above-target inflation was downright ugly. Headline CPI increased at 0.4% month-over-month (M/M) vs. 0.3% expected, and at a 3.5% rate year-over-year (Y/Y) vs. 3.4% expected and up from 3.2% prior. Core CPI, excluding food and energy, printed 0.4% M/M vs. 0.3% expected, and increased by 3.8% Y/Y vs. 3.7% expected and steady from 3.8% prior. Of more concern, on the shorter three-month timeline, core CPI has now reaccelerated to a 4.8% three-month annualized rate. Shelter inflation remained at a very troublesome 5.7% Y/Y rate, while the Fed’s favorite “supercore” measure (core services ex-housing) came in at a blistering 0.7% M/M pace that annualizes to an eye-popping 8.4% rate. In fact, “supercore” is now running at over 8.1% for the last three months annualized. As a CNBC headline put it, “the ‘supercore’ inflation measure shows the Fed may have a real problem on its hands”—and yes, indeed, the Fed certainly does have a very real problem on its hands.
Finally, adding some extra cayenne pepper to the already spicy dish of inflation sure to give Powell heartburn this week, the Atlanta Fed’s March update for “sticky” CPI inflation components jumped up significantly to 5.2% vs. its 3.6% trough last year. In short, and to reiterate, it was another very bad week for Jay Powell and the Federal Reserve.
If Powell was feeling down in the dumps and awkward following the CPI report, post-CPI commentary from Larry Summers probably didn’t improve his mood much. The former Treasury Secretary didn’t mince words with his take on inflation and the Fed. On Bloomberg’s Wall Street Week, Summers said, “I was not hugely surprised by the numbers… In the presence of massive and growing budget deficits and epically easy financial conditions, the idea that inflation would remain robust, or even accelerate, should not be a surprise to anyone, and that’s what this data suggests.” Summers went further, “on current facts, a rate cut in June it seems to me would be a dangerous and egregious error comparable to the errors the Fed was making [with its “transitory” call] in the summer of 2021… We do not need rate cuts right now.”
Summers is right given the status of the inflation variable alone. Certainly by the dictates of traditional Fed monetary policy we don’t need rate cuts at all right now. According to monetary policy orthodoxy we need more hikes. But times are changing, policymakers are behaving differently than in prior cycles, and, as El-Erian said, the history books may cite our modern moment in central banking “as marking a move away from strict inflation targeting by the world’s most influential central banks.” After all, if rate cuts are not warranted based on the inflation data, they are most certainly demanded based on the devastating impact higher rates are having on the “massive” debt and deficit blowout via the interest expense component.
Recall BofA Chief Investment Strategist Michael Hartnett’s warning last week that without 150 basis points of Fed rate cuts, interest expense on Federal debt will become the government’s #1 outlay by year-end, reaching $1.6 trillion. Hartnett’s point was that without significant and immediate rate cuts, we’ll be facing a debt death spiral and full blown fiscal crisis. In other words, with debt-spiral doom-loop dynamics fueled by high interest rates on a colossal debt pile of nearly $35 trillion, trapped monetary policymakers appear effectively unable to raise rates further to fight inflation. Rather, it looks like they’ll eventually be forced to cut rates despite inflation. It’s increasingly apparent that we’ve reached the end of the road for the era of effective modern monetary policy as we’ve known it.
Again, welcome to Powell’s pickle. He can’t cut rates because of inflation, but he can’t not cut rates because of a debt spiral. He’s in a real bind here, and the handcuffs continue to tighten each week.
Now seriously under pressure, Powell’s hope of all hopes must be to luck into some magical wave of “immaculate disinflation” to revive belief in the all-but-dead Goldilocks thesis. That said, commodity markets are conspiring to make that hope every bit as fanciful as the Goldilocks fable itself.
Commodity markets are now threatening to significantly darken the storm clouds already facing Jay Powell on the horizon. Oil is the great inflation force multiplier, and right now oil is literally threatening to pour fuel on the already simmering inflationary fire.
As HAI has been detailing for weeks, oil industry supply dynamics are tightening. U.S. shale cap-ex is expected to be flat in 2024, meaning there won’t be the added investment necessary to offset rapidly rising shale decline rates now running north of 25%. At the same time, OPEC+ has recently pledged to maintain production cuts, Russian Deputy Prime Minister Alexander Novak just ordered Russian companies to cut production in the second quarter, and Mexico just slashed its crude exports. In fact, oil shipments from Mexico, a major supplier, slid 35% last month to their lowest since 2019, and now stand to shrink even further as struggling state-controlled oil company Pemex has just canceled more supply contracts to foreign refiners. Domestically, a deep freeze in January also ate away at crude output and inventories in the US at a time when they should have grown, keeping stockpiles below seasonal averages.
On top of the tightening supply, this week Goldman Sachs added that China’s oil demand has recently bumped up unexpectedly to 15.9 mb/d and is now estimated to be close to returning to all-time high levels. The added demand out of China on tightening oil supply-side fundamentals comes as global oil inventories are declining year-over-year for the first time since 2021, with demand at present exceeding supply. And all of this comes ahead of the demand ramp attributed to the North American summer driving and construction season.
In light of these tightening oil fundamentals, a Bloomberg headline this week asks a very important question; “Are oil prices heading to $100 this summer as a global shortage takes hold?” That’s a very good question, and one that, if answered in the affirmative, threatens to turn an already bad year for central bankers downright ruinous.
For all the reasons already highlighted, the risk of $100 oil is rising significantly, but we also have a rapidly building geopolitical risk premium pressuring prices higher as well. We’ve had recent drone attacks knock out Russian refining capacity, Houthi rebel attacks on tankers in the Red Sea, and now the increasing threat of outright war in the Middle East.
A Bloomberg report late Friday crystallizes the acute geopolitical threat; “Israel is bracing for a direct and unprecedented attack by Iran on government targets as soon as Saturday, according to people familiar with western intelligence assessments, a move that has the potential to trigger an all-out regional war.” One false step here, and triple digit oil looks like a cinch. One false step here, and triple-digit oil puts a match to the inflation powder keg. One false step here, and confidence in US policy and policymakers could utterly collapse in inverse proportion to the extent gold could utterly surge.
Upping the inflationary risk on the roulette table, late Friday Bloomberg reported that the US and UK just imposed new sanctions restricting trading of Russian aluminum, copper, and nickel “that will reverberate across global metal markets.” The new restrictions prohibit delivery of new supplies from Russia to the London Metal Exchange where global benchmark prices are set, as well as to the Chicago Mercantile Exchange.
Russia is a major producer of the three metals, accounting for about 6% of global nickel production, 5% of aluminum, and 4% of copper. However, Russian supplies account for a much larger percentage of metal on the LME. At the end of March, Russian metal accounted for 36% of the nickel in LME warehouses, 62% of the copper, and 91% of the aluminum.
According to Bloomberg, “the new restrictions are likely to affect prices on the LME, which are used as a benchmark in a huge number of contracts around the world.” You can bet that the “effect” on prices Bloomberg is referring to won’t be to lower them. To the contrary, the impact will likely fuel higher prices for the metals in western markets and increase the risk of a coordinated and accelerated broad-based commodity rally that stokes further inflationary pressures.
Now, after the gut-punch of reaccelerating inflation and a third straight hotter-than-expected upside CPI surprise, the stock and bond markets are under threat. Financial assets could be on the brink of a larger move lower as investors rapidly price out rate cuts in 2024 and increase the odds of no cuts at all.
Last fall, both the bond and equity markets faltered and sold off hard when oil prices broke above $85 per barrel, inflation expectations ramped up, the dollar index jumped over 106, and US 10-yr Treasury yields broke above 4.50%. That seismic tremor in the bond and equity markets immediately preceded—likely not coincidentally—a sudden verbal pivot by many Fed policymakers toward rate cuts. That pivot ultimately culminated in Jay Powell’s following suit during the December FOMC meeting.
Today, all the conditions that triggered last autumn’s market drop are back. Oil has broken above $85 per barrel, inflation expectations are following oil higher, the dollar index is over 106, and the US 10-yr Treasury yield closed this week back at 4.50%.
This time, however, official CPI inflation is already reaccelerating higher and threatening to reaccelerate hard if commodity markets misbehave further. Financial assets could easily play a repeat track here and start to buckle again while the dollar and yields spike. In such an instance, circumstances could soon force Powell to make his choice: stay higher for longer because of inflation and risk disorderly debt-spiral dynamics, or cut rates despite reaccelerating inflation in hopes of keeping yields from spiking in order to limit the risk of both a hard landing and a sovereign debt crisis. It’s not an inspiring set of options. In essence, it’s a difficult choice between lose and lose.
HAI believes the gold market is homing in on the dynamics surrounding Powell’s lose/lose pickle. At this point, however, gold may not care which way Powell goes. Gold looks set, over time, to head higher regardless. We will have corrections along the way, one of which likely started Friday, but HAI believes there is a burgeoning financial insurance bid now intensifying and cementing gold’s ultimate breakout accent. Considering gold’s rally in spite of hawkish rate expectation repricing and resulting dollar and yield strength, an emergent financial insurance bid in the market for gold is now implied. In HAI‘s view, that’s crucial, as it’s the financial insurance bid that will catalyze the return of the western institutional buyer—the final piece to gold’s demand-side puzzle.
HAI believes that that financial insurance bid is now beginning to materialize. As Saxo Bank’s Head of Commodity Strategy Ole Hanson observed this week, it is increasingly clear given the context (hawkish repricing with both dollar and yield strength) that gold’s move higher is being driven by investors who care less about interest rates and the dollar “and more about geopolitics, rising government debt piles, and reaccelerating US inflation.” In other words, a financial insurance bid is emerging, and it’s starting to crowd out other trades to become the dominant price-setting bid in the gold market. In HAI‘s view, that’s a bull market maker for gold—full stop. Now, while gold may no longer care which wrong way policymakers go, given the circumstances, Jay Powell will certainly remain—under pressure.
Weekly performance: The S&P 500 declined 1.56%. Gold gained 1.22%, silver was higher by 3.01%, platinum was higher by 6.50%, and palladium gained 5.17%. The HUI gold miners index was off 0.83%. The IFRA iShares US Infrastructure ETF was off 2.53%. Energy commodities were volatile and lower on the week. WTI crude oil lost 1.44%, while natural gas was off 0.84%. The CRB Commodity Index was up 0.10%. Copper was up 0.57%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 3.37%. The Vanguard Utilities ETF was off 1.75%. The dollar index was up 1.65% to close the week at 106.01. The yield on the 10-yr U.S. Treasury gained 11 bps to close at 4.50%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
