Full script:
Good day, ladies and gentlemen!
Welcome to our Singapore Macro Strategist channel!
Our webcast topic today is, “The current inflation is a real and present danger!”. We are doing a follow-up topic after the FOMC meeting on 15-16 June 2021 to provide an in-depth insight into the mind of the US FED.
As reported, the US inflation in May 2021 was 5% year-on-year which was caused by rising prices in used cars & trucks, and airfares. Moreover, the producer price index (PPI) was also reported to be 6.6% higher on a yearly basis. The huge increases in PPI & CPI meant that the producers managed to pass the higher costs to the retailers which in turn had passed on the higher costs to the consumers. However, the US retail sales fell 1.3% year-on-year because the consumers started to cut back on their spendings in the face of higher inflation. The cutback in consumer spendings meant that the continual increase in retail sales was unsustainable.
Conversely, the US retail sales had been on an upward trend since 2020 because of the US$16.7T stimulus packages insofar, particularly the multiple government doles known as free stimulus cheques. This unsustainable uptrend has already exceeded 15% from its mean and we expect it to do a mean reversion in the future.
Furthermore, the annualized wage growth had started to decline which was not in sync with the higher inflation. Therefore, we expect the US consumers to be more frugal in their spendings in the future which will thwart the growth in retail sales.
The US FED had announced during its FOMC meeting that it would continue its monthly quantitative easing program such as the US$40B mortgage-backed securities (MBS) and US$80B treasury purchases, and also to continue its low-interest rates until 2023.
The low-interest rates and MBS purchases had pushed up the home price index to an all-time high because of the indiscriminate mortgage loans since the financial institutions could transfer the mortgage risks to the US FED. The reckless house purchases had caused a housing supply shortage which in turn had created widespread increases in rentals. Since the US FED did not wish to trigger a housing crash like before, it had decided to keep its low-interest rates policy.
Consequentially, the US$16.7T stimulus packages over the last 2 years had created some financial bubbles, excessive liquidity, and higher inflation in the economy which needed to be resolved. However, it could not increase its benchmark rates to reduce the inflationary pressure. Neither could the FED afford to burst the burgeoning financial bubble by hiking its benchmark rates.
The excessive liquidity in the financial system could be detected in the daily reverse repo market whereby the US FED had taken in about US$750B in a single day. This huge amount in a single day had contradicted and exceeded many months of the FED’s US$120B monthly QE program.
Currently, the US FED has accumulated about US$8T of assets through its QE program. In other words, the US FED had released $8T US dollars into the financial system which had boosted the stock market to a record high. This chart will show a very high correlation between the FED balance sheet and the stock market. Thus, when the US FED begins to do its QE tapering by selling its assets, the stock market will fall inevitably.
When will the US FED begin its QE tapering?
The global fund manager survey shows that the US FED will begin to plan its QE tapering in the next FOMC meeting and likely to implement it in Q1 2022. Therefore, the US market is unlikely to enter into a bear market in 2021.
We think by now, we have proven our opinion beyond reasonable doubts that the current inflation is a real and present danger, and that the inflation is not transitory as what the FED has proclaimed it to be.
Nonetheless, we will analyze this so-called “transitory inflation” from another perspective.
The US FED, which was privy to all the economic data, had made a PCE inflation projection for March 2021 at 2.4% by factoring in the low base effect in 2020. However, the actual PCE inflation was 100 basis points higher or 42% more than its projection. This showed that the reported higher US inflation was unlikely caused by the low base effect. Furthermore, the annualized 3-month headline CPI change also corroborated this view since it did not surpass the last few previous highs which it otherwise would due to the low base effect.
What are the factors that will cause the current inflation to persist longer?
As mentioned earlier, the housing sector will provide the oomph for inflation to rise further in the future. Simultaneously, there is a current inventory shortage now, as indicated by the low inventory to sales ratio, which will keep the CPI high for a longer period. Last but not least, the crude oil price is projected to rise further from the current US$70 price due to the pent-up demand from the reopening of the economy.
What are other factors that will affect US inflation directly and indirectly?
The China credit impulse is a major factor that will affect the US economy and inflation because of its significant effect on the USD.
What is a China credit impulse?
The China credit impulse is defined as the credit growth to its GDP ratio. In a nutshell, it is a measurement of the growth in debt as a percentage of GDP.
The China central bank is currently embarking on a monetary tightening policy because it is the best time to deleverage without hurting its own economy when another big country like the US is leveraging.
When China starts its monetary tightening, it will reduce its credit impulse which will cause the USD to appreciate and the demand for the base metals will decline consequently. Simultaneously, the USD appreciation will also cause the treasury yield to rise since USD and treasury yield are positively correlated over a long period. Please take note that the treasury yield may not correlate well with the USD in the short term because of the lagging factor but they will conform to the correlation over a long period.
The next chart will show the positive correlation between the China credit impulse and industrial metals.
As we are aware, the USD appreciation will help to reduce the US inflationary pressure by increasing the consumer purchasing power. For your information, the USD had been rising recently as shown on the USD index.
How is the US treasury yield related to US inflation?
The US treasury yield forms part of the inflation expectation or the breakeven rate and its effect on inflation can be extrapolated from the formula.
Let’s take a look at the inflation expectation or breakeven rate now.
Let’s take a look at the latest figures on 18 June 2021.
The 10-year treasury yield was at 1.45%
The 10-year TIPS was at -0.79%
Therefore, the inflation expectation was at 2.24% on 18 June 2021. The formula has shown that any changes in the treasury yield and TIPS will affect the inflation expectation. Consequently, the inflation expectation will cause people to develop a self-fulfilling prophecy which will cause real inflation in the economy.
Thus, it is important to monitor the treasury yield as it can serve as a precursor of any impending financial shock. The global fund manager survey showed that a yield of 2.3% could cause a 10% correction in the stock market.
What will the US FED do to rein in US inflation?
The latest dot plot chart shows that the US FED is likely to hike its benchmark rates twice in 2023 to contain inflation.
However, the probability of the US FED rate hike by the end of 2022 has increased tremendously to over 90%.
Did the US FED do anything after the FOMC meeting?
The US FED had allowed its rates to rise slyly despite holding its benchmark rates at 0% to 0.25%.
What are the rates that have risen?
The US FED uses the following rates to manage the US economy:
1. Effective federal funds rate (EFFR) - The EFFR is currently set at 0.25% by the US FED and is the upper limit of the benchmark rates.
2. Interest rate on required reserves (I-O-R-R).
3. Interest rate on excess reserves ( I-O-E-R).
4. Overnight repo rate (O-N-R-R) - O-N-R-R is currently set at 0% by the US FED and is the lower limit of the benchmark rates.
Let’s take a look at the rate changes after the FOMC meeting.
The EFFR had increased to 0.1% after the Fed meeting.
The I-O-R-R had increased to 0.15% after the FED meeting.
The I-O-E-R had increased to 0.15% after the FED meeting.
The overnight repo rate had maintained at 0% but the reverse repo rate had increased to 0.05% after the FED meeting. This increase in reverse repo rate also caused an influx of US$747B in a single day. In a way, the US FED had conducted its QE tapering discreetly to deal with the excessive liquidity in the financial system.
All these rising rates showed that the US FED was very concerned about the current high inflation because it allowed the rates to rise within the band limits.
Finally, we have come to the end of our video and we thank you for your support.
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