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Deflation Fears Are A Distant Memory

A whirlwind of data this morning left the market undisturbed. Retail Sales and PPI came in as-expected; Initial Claims was stronger-than-expected by 10k, but last week was reviser weaker (higher) by 9k so that was a wash as well. The trajectory of Claims looks better, with today's 405k the best number since April, but we would need a few more weeks of such improved data to say that things are moving in the right direction again. I'm not terribly optimistic that one week below 420k augurs great improvement, especially with seasonal adjustment issues around auto re-tooling, but we can always hope.

More newsworthy, but only just, was Bernanke's reprisal of yesterday's Monetary Policy Report to the Congress, in front of the Senate today. In Q&A, the Chairman clarified that the fed is "not proposing anything today" including explicitly a new round of QE. Somehow, people had gotten the wrong idea from the headlines yesterday, and from CNBC. I don't think that was unintentional except in the sense that to shill for stocks is reflexive for many of these observers. But there wasn't much room for doubt around Bernanke's statement today, and equities fell partly as a result (more below about why QE3 becomes increasingly unlikely as time passes, absent a major calamity).

Bonds fell too. Partly, this is a reaction to heavy supply which had previously been taken up by the Fed; dealers now actually have to find real buyers for the stuff and typically it helps to mark something down to sell it. We will see how long it takes for buyers to be truly saturated, but it may take a while.

TIPS buyers also got markdowns today with the 10y TIPS selling off 9bps to 0.61% after the Treasury announced that it will auction $13bln of a new 10y security next week. That wasn't a huge amount when the Fed was sucking them up regularly but again, it helps to mark 'em down if you're going to sell 'em. I am not terribly worried about either nominal or real U.S. debt markets right now.


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The biggest concern to me about tomorrow's CPI is that right now, before the data comes in, the trajectory of core CPI is already exceeding the projections of all of my models. Last month's 0.287% rise in core was the highest monthly figure recorded since 2006, and has helped produce the most looking-like-a-trend chart in inflation in a long time (see Chart).

Chop, chop chop...until the last 9-12 months!
Chop, chop chop...until the last 9-12 months!

I mean, look at that chart! Ordinarily the month-to-month wiggles are mostly noise. The last 9 or 12 months' worth of data almost look like they come from a different series. It is therefore very hard to immediately dismiss this move higher. As I pointed out last month, too, all of the subcomponents of CPI accelerated their Y/Y prints except "Other Goods and Services." So there are some reasons to be concerned that there may be something going on here.

That sense will be greatly enhanced with another 0.3% on core CPI tomorrow. The consensus looks for 0.2%, but an unblemished 0.2% (as opposed to an 0.155% that merely rounded higher) would also push the year/year core CPI to 1.7% (economists are hedging their bets by expecting a 1.6% y/y core CPI along with an 0.2% monthly, so they're effectively calling for a "soft" 0.2%).

By the way, even if the 0.3% turns out to be an aberration and we see 0.15% for the balance of the year, be aware that because of base effects - that is, core price inflation the second half of last year was extremely soft - such a performance would result in y/y core inflation reaching 2.3% by the end of the year. If we get 0.2% each month, we'll be at 2.7% by the end of the year. This is the context to keep in mind when you're thinking about the likelihood of QE3. QE2 was issued into the teeth of what the Fed knew was likely to be very low core prints for a few months in late 2010. But QE3, if it were to happen this year, would happen with core inflation already scripted to be well above target by year-end.

Now, it is also possible that sagging home prices could pull down rents, which in turn keeps a lid on core CPI. One of my models considers housing separately and produces a soft forecast as a result (but the forecast is still more or less in line with my other models overall). But this is hardly encouraging, since it would mean that deflationary pressures in one part of the economy are masking inflationary pressures in the rest of the economy. Or, to put it another way...core inflation, ex-housing, is likely to approach or exceed 18-year highs by the end of the year. I will run that chart in my post-CPI article tomorrow (or Sunday, depending on my ambitiousness tomorrow).

As core inflation moves almost inexorably higher, driven by secular pressures of debt and monetization, the inflation market itself has begun to back away from forecasts of high medium-term inflation. The chart below shows the core inflation implied in the quotes of 1-year inflation swaps (which are structured on headline inflation, but from which I have extracted implied energy inflation). When implied core was over 2.5%, it was clearly mostly pricing tail risk; now that it is at 1.6% it seems like it is pricing tail risk in the other direction!

Implied Core CPI from inflation swaps for the next year is only 1.6% or so.
Implied Core CPI from inflation swaps for the next year is only 1.6% or so.

Also out tomorrow is the Empire Manufacturing figure, which shocked everyone last month by plunging to -7.79 from 11.88, versus expectations for 12.0. The consensus call this month is for a bounce all the way to +5.0, in effect suggesting that the dip was a seasonal aberration or temporary effect. Industrial Production (Consensus: +0.3%) and Capacity Utilization (Consensus: 76.9%) are not too important. The Michigan Sentiment figure (Consensus: 72.0 vs 71.5 last) has been quite stable at a low level for a while.

The backdrop for fixed-income continues to be poor, but the wildcard of a budget deal which will happen sometime in the next two weeks make it hard to argue for putting on shorts. Equities too will face trouble rallying if investors keep trying to lean on improvement in Europe - which appears to be shifting back into reverse - and the possibility of QE3 which the CPI figures will soon squelch. Implied volatilities have been rising; even though the S&P has fallen less than 1% since Monday, the VIX has risen from 18.39 to 20.80. I think that fear is justified.


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