April CPI to Add to Inflation Story

Later this morning we get April CPI and the equity market hasn’t waited around to sell on the rumors. Expectations are that overall CPI will reach a ten-year high of 3.6% while core CPI is expected to spike to 2.3% versus 1.6% in March. This is the base effect and supply constraints that the Fed has been talking about for months. While the fixed income market has been taking the inflation news with calm and little reaction, stocks are another story altogether and we talk about those differing responses in the section below. Finally, in our latest podcast, Tom sits down with Joe Keating, Co-Chief Investment Officer, NBCS Asset Management to   discuss his latest thoughts on the economy, rates and stocks.  The iTunes link can be found here and the Spotify here.

 


A Tale of Two Markets

The inflation story continues to bedevil stocks while bonds remain relatively sanguine. It’s like the adult pool at a family resort: quiet, without a lot of action while over in the equity side it’s all manner of chaos. So which side is right? After years of working in the industry we can say this: when two different markets react differently to the same information we tend to come down on the fixed income side. Part of that is because we work in that side of the business but also because when there are big macro-economic moves afoot the fixed income side seems to have a better handle on those forces. While stock jockeys understand company-specific advantages and weaknesses, when macro factors intrude they often revert to knee-jerk responses. That’s what we think we’re seeing now. The high-multiple stocks are getting hit for the implication that higher inflation is coming and here to stay. Fixed income, on the other hand, being better students of macro-economic moves and the Fed seem to have a more calm hand on the tiller. View the TIPs Breakeven Inflation Rates below. The 1yr inflation rate is 2.89% which is high but look at the 10yr breakeven inflation rate at 2.53%.

 

Source: Bloomberg

We think the Fed would take a 2.53% inflation rate over a decade in a heartbeat and that may explain the relative calm in the Treasury market of late. The Fed has spent considerable energy over the last couple months explaining the expected transitory price increases we’re now seeing. The fixed income market seems to have taken that to heart. The stock market? Well, not so much. We think that within a year or so, longer-term forces that kept inflation under 2.00% despite a 3.5% unemployment rate prior to the pandemic will return to influence prices lower once again. Aging populations and lower population growth in all the major developed markets, global supply chains returning to low-cost producers, and technological advancements will slowly exert their influence just as fiscal stimulus fades. Price levels will inevitably follow.

 

Lumber Prices Slow Home Building

So we follow up our piece on inflation and not to worry about  it with a piece on the staggering increase in lumber prices. As shown in the graphic below, $50,000 in lumber would have built just over ten houses in 2020 and that same price of lumber would build you just over 2 houses today. And that’s the point. It’s not just that the sky-high lumber prices are being passed through to the consumer in the form of higher home prices, it’s also that those prices are slowing the homebuilding process.

 

If you look at any recent residential activity report, the lack of inventory is almost universally mentioned as a constraint to more sales and as a catalyst to higher prices.  Home builders are more often than not, slowing the pace of building as lumber prices continue higher and that will slow the pace of activity in the second half of 2021. One of the foundations of inflation building through 2021 was the expectation of re-openings creating all manner of demand that would in turn lift prices even higher. Well, if supply is constrained due to high prices then the expected level of activity will be constrained as well and that leads to the self-limiting impact of higher prices. Without ever-increasing wage gains, at some point the consumer balks and limits discretionary spending. The April jobs report could be a harbinger of more to come: a lumpy, longer-than-expected recovery and that should also have a dampening effect on prices in the longer-run.


Agency Indications — FNMA / FHLMC Callable Rates

Maturity (yrs) 2 Year 3 Year 4 Year 5 Year 10 Year 15 Year
0.25 0.12 0.33 0.65 1.02 2.09 2.55
0.50 0.10 0.30 0.59 0.91 1.94 2.43
1.00 0.10 0.27 0.56 0.87 1.85 2.31
2.00 0.26 0.50 0.79 1.74 NA
3.00 0.74 1.67 NA
4.00 1.63 NA
5.00 1.59 NA
10.00 NA

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Published: 05/11/21 Author: Thomas R. Fitzgerald