Last week was the week of inflation data: The CPI report shows the possibility of inflation turning back and surging uncontrollably. The PPI report shows inflation still under control

Meanwhile, the impact of the CPI inflation data made Fed officials' stance on Thursday and Friday more hawkish - warning that the Fed may delay the pivot plan to continue monitoring the economic situation.

• So what factors are causing the CPI inflation to surge again?

• The Fed's stance on interest rates may become more hawkish, but what will the Fed's QT plan be like in the coming months?

• And most importantly: how is maintaining a high interest rate environment and withdrawing liquidity from the market (especially during tax season) affecting the debt market? 

  • And why is the debt market more likely to create a financial crisis than the stock market?

Based on the macro data and market observations from last week, Viet Hutsler's Weekend Macro Economics article will provide explanations for the questions above. 

Disclaimer: Some of the views below are the personal opinions of the author and are not investment advice at all.

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CPI inflation higher than expected: what are the causes?

Last week's CPI report shows the risk of inflation getting out of control as it rose higher than estimates:

• Actual March CPI increased +3.5% y/y higher than expectations of +3.4% y/y and +3.2% y/y in February. 

  

• Although the PPI report one day later was lower than forecast (+2.1% y/y vs +2.2% forecast)… it still couldn't change the risk of uncontrolled inflation from the CPI report.

  • Because PPI uses seasonal adjusted gasoline and oil price data - it doesn't reflect the actual high oil price situation.

    

• Viet Hustler has reported in detail CPI report and PPI in daily market articles.

However, the message that Viet Hustler wants to convey in this article is:

The two-way relationship between inflation and the commodities market

In the first more than 3 months of the year, there were many times when the commodities market rallied stronger than the stock market.

• (even when the stock market rose strongly thanks to the tech sector)

• The global commodities price index (S&P GSCI) has risen 11% this year, far exceeding the 9.2% gain of the S&P 500. 

  • Copper prices up >10% and crude oil >16%, gold prices repeatedly hitting new highs.

The two-way relationship between inflation and the commodities market is quite clear:

1- The commodities market rally reflects recovery in major economies but also makes commodity prices more expensive - inflation becomes more persistent:

A typical example is gasoline and oil prices:

• Last week, manufacturing activity reports from both the US and China showed signs of recovery in the manufacturing sector.

  

• This revives the wave of new buying – boosting stocks of energy and materials companies, 

• But it also causes gasoline prices to continue climbing right before the summer holiday - when driving vacation demand increases.

  • Typically, the clear rise in oil prices has caused the CPI basket to rise (while PPI with seasonally adjusted oil prices is much lower).

2- Conversely, surging prices of raw materials for production and transportation also show that investors are betting on prolonged inflation or even a resurgence.

Investors continue to bet on high commodities demand in the near future, causing commodities futures contracts to surge strongly in the past 2 weeks:

Reasons for the above bets:

• Real income growth + rising net worth of US households signals strong commodities demand.

=> possibility of prolonged inflation.

• Not to mention the escalating conflicts in Russia-Ukraine and the Middle East are also pushing up oil and gas prices (fuel for many manufacturing industries).

  • Read more: Geopolitical risks affecting the financial markets

=> Therefore, the Fed will need to closely monitor the commodities market during this time to ensure that inflation does not turn around and rise again.

The Fed may not rush to cut interest rates and reconsider slowing down the QT process

• Hawkish statements from a series of Fed officials last week all indicate that the Fed may push back the interest rate cut plan compared to initial expectations.

However, what stands out in the March FOMC meeting minutes is that FOMC members discussed the possibility of gradually reducing the QT pace to half.

• Currently, the Fed is conducting QT at a pace of reducing ~ -95 billion USD/month in assets on the balance sheet (by selling MBS, bonds, and stopping bond reinvestments…)

• Gradually reducing QT is also a preparatory step for pivoting on interest rate policy, to ensure that interest rate-monetary policy proceeds in tandem (2-tier system)

  

However, the FOMC Minutes were prepared before the CPI report was released!

With last week's CPI data, the Fed will likely soon push back this plan to gradually slow QT following the high CPI inflation data from last week.

• Especially since last year's BTFP policy made the previous QT not very effective – one of the reasons for persistent inflation.

  

  • Read more: Timing of Fed stopping QT vs banks' cash reserves

• The fiscal tool to support the Fed's QT operations to curb inflation from rising again this April is "tax collection season begins":

  • It can be seen that in all tax collection seasons, a large amount of liquidity can be withdrawn from the market and returned to the US Treasury…

    … deposits at the Fed will also decrease significantly as banks need liquidity:

  

• And this year's tax season kicks off with the first withdrawal of funds from the money market (bonds and short-term deposits):

  

• April CPI and PPI data (released in mid-May) will tell us whether inflation cools down thanks to this tax season!

However, it can be seen that the impact of QT will be even greater (due to the impact of tax collection) in the near term …

• …. rather than decreasing as suggested in the FOMC Minutes.

Higher-for-longer and crisis warnings from the debt market

The longer the Fed maintains high interest rates and prolonged QT – the higher the likelihood of a financial crisis escalating in the debt market

• Even if the stock market rallies due to tech fever, most businesses still need capital from the debt market.

• Fact: the debt market is always much larger than the stock market!

  

And the truth is:

All financial crises come from the debt market (including bank borrowing => banking crisis). 

Meanwhile, the stock market only crashes right when / after a debt crisis occurs. 

Therefore, we cannot equate a stock market rally with the health of the financial markets!

Meanwhile, the debt market becomes increasingly vulnerable when interest rates rise and liquidity is scarce (due to QT). 

A few current risk aspects of the debt market

Commercial Real Estate market (CRE)

• The CRE market is in a tense phase when delinquency rate and ratio of CMBS contracts with special servicing (special servicing) are all surging sharply.

  

  • FYI: CMBS are derivative securities created from the securitization of a pool of various commercial real estate loans.

    • Details on securitization activities were mentioned by Viet Hustler in the article about the 2008 financial market crisis.

    • CMBS (Commercial Mortgage Backed Security) contracts only require special servicers to step in once the mortgage borrower is at risk of default. 

    • The main tasks of the special servicer are to assess the borrower's liquidity situation and urge/assist them in repaying the debt – which may include helping them restructure the debt (details here)

  • As shown in the image above, currently about 7.4% of CMBS / mortgage contracts in the market show signs of default (requiring special servicer intervention).

  • Due to the complexity and interconnectedness of CMBS, if the commercial real estate debt market collapses, the contagion risk will spread to many other financial institutions.

    • For example: banks, insurance, debt market funds, non-bank financial institutions (NBFI), and retail investors buying CMBS…

    

• Viet Hustler also has a more detailed weekend article about the current commercial real estate market situation yesterday.

Consumer debt market

• The credit card delinquency rate as recorded by the Fed has reached the highest level since the Fed began tracking this data. 

  

Mortgage lending market

• Mortgage rates have risen again, above the average of 7.0% last week (30Y fixed-rate purchase contracts).

  

• This leads to the US mortgage debt market at risk of freezing as mortgage application volumes drop to the lowest level in ~3 decades:

  

• An article at WSJ pointed out that, to sell a house, even sellers have to accept providing credit to buyers by letting them pay in installments…

  • because buyers do not qualify for mortgages with high insurance premiums.

  

The corporate debt market currently shows the fewest signs of crisis

• But once this market shows clear signs of crisis (such as high default rates), a financial crisis has actually already occurred. 

A few signs of imbalance in the current corporate debt market:

• Companies are rushing to announce new debt issuances, with the value of new debt in the first two months of 2024 — 3 times that of December 2023.

  • This warns that companies' old debt is gradually maturing and they have to refinance at higher interest rates than the old debt: 

  

• In addition, the US corporate credit market value as a % of GDP is declining:

  • Currently, this ratio is still at a safe level but trending downward.

  • This shows that not every company chooses to refinance debt at high interest rates when old debt matures.

    

  • Corporate debt growth is also slowing even though nominal GDP growth is still increasing.

    

The only reason the corporate debt market is holding on might be:

•  Companies' cash reserves from the Covid period are still quite abundant (along with the generous QE from that period).

• Accompanied by high profit margins over the past year due to strong consumer demand.

  

CONCLUSION

The debate comes from uncontrolled CPI growth while PPI growth remains low, leading to the question of what is the true direction of inflation? Viet Hustler's view leans toward the possibility that inflation risk is actually rising again if looking at the rally in the commodities market in the first 3.5 months of the year:

• The commodities market is heating up due to expectations of increased demand from rising household income / net worth in the US.

• Supply shocks due to geopolitical risks are also pushing commodity prices higher (including oil prices, raw material prices, and gold prices…)

In this situation, the stance of Fed officials seems more “consistent” than before, all leaning toward the “hawkish” extreme. Therefore, the possibility that the Fed postpones the rate cut plan and the QT reduction plan to the end of this year is entirely possible.

The Fed may need to continue monitoring inflation and labor data in the coming time to decide.

Of course, there is still hope that inflation can cool down in April (and May) after this tax season. Tax collection will amplify the impact of QT as market liquidity decreases (though not significantly). At least, tax season is also an opportunity to reverse the liquidity injected into the banking system by the Fed's previous BTFP program.

Finally, the most important message that Viet Hustler wants to emphasize is: don't take the pulse of the financial market's health through the stock market! Because the value of the stock market is much smaller than the gigantic debt market. Meanwhile, the debt market is extremely sensitive to fluctuations in interest rates and liquidity.

In the recent period, signs of cracks in the debt market: from real estate debt + mortgage, to consumer debt and corporate debt are increasingly evident due to the high interest rate environment. The question is, how much longer can the debt market hold out if the Fed continues to maintain high interest rates this year.