ANDREAS STENO LARSEN: Good afternoon, folks. And welcome to the Real Vision Daily Briefing. I'm Andreas Steno from Real Vision, sending to you live on the heels of the US CPI report. The peak is in in inflation, at least in my humble opinion. And that is also what we've been told I think by various surveys over the past month. And unless SMEs are not telling the truth, then I guess it is fair to assume that the trend is now down for the time being in headline inflation.
But I've invited a couple of tremendous analysts to help us unpack the inflation environment and whether I'm writing this bold statement. So, first of all, welcome back to the show to you Darius Dale, founder of 42Macro.
WESTON NAKAMURA: Andreas, what's up, buddy? How are you?
ANDREAS STENO LARSEN: I'm good. And I hope you're great as well. And also welcome to you, Weston Nakamura, the markets editor at Real Vision.
WESTON NAKAMURA: Thank you. Well, how are you, gentlemen?
ANDREAS STENO LARSEN: Good. Guys, I'll give you the chance to comment on my slightly cocky message that inflation has already peaked. Darius, do you concur with that view? Yes, or no?
DARIUS DALE: Yeah, totally. So, I think it's very clear that inflation has peaked. If we could throw up a couple charts to elucidate this from a data standpoint, Claire, if you don't mind, go to Chart 76, I'll start with that one where we show all the various key categories of headline inflation. So, we saw headline CPI roll over 140 basis points when you look at it on a three-month annualized basis, to 9.2%, obviously, still very high relative to the pre-COVID trend, but that's a pretty sharp deceleration.
Foods inflation actually accelerated 90 basis points. So, that's moving in the wrong direction. But clearly, what's driving the big rollover and headline is this big sharp deceleration in energy, CPI off 830 basis points to 26.5% on a three-month annualized basis, but to me, I think it's less about the headline that the markets are celebrating. And really, it's about the dynamics and core, Claire, if you go to Slide 77 as well.
We saw core CPI rollover 100 basis points on a three-month annualized basis to 6.6%. Now per Charles Evans who spoke after the report, he's the Chicago Fed President, still unacceptably high at 6.6% relative to the pre-COVID trend of 2.1%. But obviously moving in the right direction. And what I thought was the most important in the inflation report is this breakdown we saw in core services inflation, off 150 basis points to 6.7%.
So, to answer your question, my friend, when you get breakdowns like this on a momentum basis, it portends very good news on a go-forward basis from the perspective of the year-over-year time series.
ANDREAS STENO LARSEN: Weston, I will also allow you to unpack the market dynamics around this inflation print. What's been on your radar across assets?
WESTON NAKAMURA: Yeah, so I'm not going to follow Darius with that. So, what I'm going to do is I'm just going to give just this very broad cross asset reaction to what we had with the CPI print. And the reason is because as I said on Monday, as I mentioned on Monday, so Jay Powell at last FOMC, following Christine Lagarde, basically he killed off forward guidance and he's saying that we are going to take this month by month, and we're going to take it meeting by meeting.
And so, essentially, what that means is that if he's going to be data dependent, when you have data, especially CPI prints coming out, that is essentially the new FOMC like Powell press conference, if you will, if this is how he's choosing to express what the Fed is going to follow. So, we had more or less a meeting or a press conference this morning and markets were certainly very much pent up for that. And you saw some significant moves, especially in futures markets on some significant volume.
But before I get to that, I just wanted to-- before I forget myself, I just want to remind people that if these data prints are these FOMC press conferences, if you will, then we have to keep in mind that there's one more CPI print that will come before the next September FOMC meeting. So, I believe it's on the 21st is the FOMC announcement, but the CPI for this month is going to be on the 13th. So, the way that I'm looking at it in terms of month-over-month, the CPI today versus September is the month-over-month that really matters.
With that said, just in terms of price action that really caught my attention obviously, so we saw a massive rally in NASA futures were up 2% right upon the release itself, VIX cracked below the 20-handle intraday today. And so, obviously, equities, risk assets, Bitcoin, all that were flying quite high. In terms of the bond market however, though, so five-year breakevens, that fell back towards its recent lows of 2.5%, but five-year five-year inflation swaps, those inched higher to I think it's about two, a little bit over 2.5%, so slightly above recent lows. And those were more in line with the Fed's 2% PCE target.
So, I'm watching that, and I'm also watching the dollar. And so, DXY broke the 50-day moving average, but it's not just a dollar selloff story in and of itself, probably going to guess I'm going to be looking at the yen. It's also a yen buying story. We saw dollar/yen drop 1.5% upon the release. Euro/yen also dropped half percent or so. So, there is also a lot of yen short covering as well. And basically people closing out that policy spread between the FOMC, or the Fed and the BOJ as well.
So, a lot of moving parts. But like I said, we still have PPI tomorrow, we still have another one of these prints ahead of the next September meeting.
ANDREAS STENO LARSEN: Darius, we have equities up, we have a weaker dollar, and we have slightly lower bond yields over the past couple of weeks here. I guess that's the textbook market reaction to the mixture of data that we've received over the past couple of weeks.
DARIUS DALE: Yeah, to be very clear, the data we've gotten for July to date, particularly on the hard data front, or at least on the main the primary indicators have been very clearly Goldilocks. It started last week with the ISM services print, big positive surprise, it was a very healthy print from the perspective of the internals, followed by the jobs report, which obviously it was a gangbusters report, whether or not you believe it or not, it is irrelevant from my perspective as a risk manager.
And then obviously, today, we get this very dovish inflation reading. And so, when you add those three factors together, it's pretty clear that the market's been trading like Goldilocks, really, since late June. And this is obviously we're getting the river card here from an economic data standpoint. One thing I think that's been very instructive, at least for markets today, was the breakdown in some of the leading drivers of core PCE. And Clair, if you put that chart, Slide 79, up, where we show trim mean PCE inflation, median CPI, sticky CPI and core PCE, and we're showing these on a month-over-month annualized rate of change basis, as opposed to a three-month annualized.
And the reason we're showing these particular indicators on a month-over-month annualized is because we think this is a market that's looking for the easiest, quickest path out of the tightening scenario. And so, we're still trying to find, when do these indicators get you to a level that would seem to suggest the Fed will be comfortable finally instituting the faint policy pivot that everyone thinks has already happened.
But I draw your attention in this particular chart on Slide 79 to the two clusters of bars in the middle of the chart, median CPI, which the Cleveland Fed maintains, that number declined 250 basis points to 6.3% month-on-month annualized. That's a sharp slowdown and median CPI across everything in the broader basket. Now, obviously, it's 6.3% month-on-month annualized, we're way north of the 2.6% trend we experienced in the pre-COVID era. But that's obviously a big, big move we've seen in the right direction.
Secondarily, sticky CPI, almost equally as important as a driver of core PCE, decelerated 270 basis points to 5.4%. These are big moves. And the most important thing about these big moves is that they're happening outside of an actual recession. Typically, what happens in and around the business cycle is that you need the actual decline in aggregate demand to cool prices, sticky prices, median prices, core prices, wages, etc.
And we're not necessarily seeing the traditional order of operations, if you will. We're getting the breakdown in inflation without necessarily seeing the real true organic breakdown in aggregate demand. And that's obviously incredibly positive for asset markets if you think about this and play it forward in terms of the Fed's reaction function.
ANDREAS STENO LARSEN: No one's better at unpacking these details than you, Darius, I love it. If we go back to you, Weston, if we look at market positioning, I know that you've been looking into the dollar positioning, for example, versus the yen over the past month. How do you gauge the positioning in dollars and for example, equities post this CPI report?
WESTON NAKAMURA: Yeah, so in terms of positioning, what I'm looking at is the yen, like I kept saying over again, is the Fed trade for many just because of the fact that front end Eurodollar futures implied volatility is just astronomical to the roof. And so, therefore, traditionally when rates traders would make outright bets on where Fed Funds policy is going to be, and at what level, at what time and all that, at this point with front end vol so high, what they're doing instead, what they have been doing is just playing the policy divergence versus the BOJ, this static easing central bank versus a very hawkish, potentially hawkish one.
And so, as that closes up, or as that widens, that gives more of a cleaner read, I suppose, on the overall market view on that. The short yen position that was very, very crowded over the last, let's call it two months or so, June and July, that has become much less crowded, however, there is still massive outstanding position of short positions on yen, but yen has started to recorrelate back with something like Dec 22 Eurodollar futures, which used to move in tandem with dollar/yen.
So, that short squeeze is initially over from that started with the FOMC meeting itself, then continued on through GDP that had US in technical recession, and so on, so forth, then started to reverse with what Darius is mentioning, with the stronger services ISM, and so on, so forth. So, right now, positioning in terms of the currency markets seems to be still positioned for a stronger dollar.
So, if you start to see that unwind, I think it could really cascade, I don't know at what point and from what angle, I don't know if it's going to be from the Euro, from the yen, or whatever it is, but they could trigger one another and that could seriously, temporary or short term, it could seriously derail the dollar rally. And that can potentially be another lift to risk assets.
ANDREAS STENO LARSEN: If we look at the latest positioning data, I still think the yen is one of the most hated currencies worldwide, while the positioning versus the Euro is particularly more square than it is versus the yen when it comes to these dollar futures. I wanted to ask you as well, Darius, on the question of the dollar, could this CPI report be a game changer for the whole positive dollar narrative?
DARIUS DALE: Yes, so it goes back to, so what are the fundamental drivers of the dollar, the dollar tends to work in in two specific scenarios. One when the US economy is accelerating very aggressively and outperforming the rest of the world. And two when the US economy is decelerating quite meaningfully alongside the rest of the world. Everything else tends to be a negative dollar event. This is what we in institutional finance call the dollar smile thesis. And this thesis is definitely born of the data.
When you think about the dynamics that could perpetuate a breakdown in the dollar, you need to either see one of two things happen. One, recovery, the global economy, US and global economies, we don't think that's necessarily a high probability event, just given the lagged impact of tightening we're likely to continue to realize in the economic statistics. Secondarily, you could get a real material slowdown in the pace of deceleration. And that, to me, is the new thing that markets have to discuss and debate because you're talking about a very different set of annualized expected return profiles for things like the dollar, the S&P 500 risk assets broadly.
Going back to this discussion on median CPI and sticky CPI, actually, just put that chart back up, Slide 79, Claire. The one thing I will call out is that we've lost 250 and 270 basis points respectively from those time series on a month-over-month annualized basis. So now, we're at 6.3%, or 5.4%. If you just linearly extrapolate that 250-ish-basis-point decline, we're going to be right around 4.5% month-over-month annualized for core PCE, that's a significant deceleration from where we were in the most recent month.
Now, the quick question for asset markets is, do we maintain this pace? Because if we maintain this pace, two extremely positive things are going to happen. One, we're going to get core PCE, the Fed's preferred inflation leading indicator to break down to a level that's consistent with them finally pivoting from the perspective of the policy. But more importantly, I think, possibly equally, as importantly, if we get that sustained breakdown in inflation over the next few months, it's going to arrest the rate of decline in the US economy.
After all, a lot of the degradation we've seen thus far has been on a real basis, not on nominal basis. And so, you could actually create optical lift, if you will, to real growth just as a function of that decline in inflation, which again is very anomalous, and I'm rambling a little bit here. But let me just land the plane, if you put up Slide 89, we were showing on Slide 89, it's a very important chart, it shows call it the year-over-year rate of change of core PCE in the upper panel. And in the two lower panels, we show the 17-month rate of change, and a 23-month rate of change.
Why those two specific durations? Well, the Fed is targeting 2.7% core PCE in the yearend of 2023. So, 17 months from now, and then being the nice guy that I am, I've given them an extra six months to get to their forecast, so that's effectively 23 months away. When you look at it on a rate of change basis, we've never seen core PCE decline the kind of decline that they have currently baked into their forecasts without experiencing recession.
And so, this goes back to my point. It'll be very anomalous relative to the market and economic history for inflation to just break down like this without seeing that big breakdown in aggregate demand. But if it happens, it's obviously incredibly bullish. There's no ifs, ands, or buts about that, and bearish for the dollar.
ANDREAS STENO LARSEN: Yeah, I think the Fed managed to create a soft landing during the early 1990s. But that's right about the only time in history where they actually met us to do so. What's your implied probability of an actual soft landing now, Darius?
DARIUS DALE: No, it's got to be higher. I think anyone managing risk in financial markets, looking at the kinds of declines we're seeing in these very key leading indicators, you have to acknowledge that the probability of a soft landing is much higher. And if we stick at minus one to 250 basis points in terms of shaving that momentum off of core PCE and core inflation pressure over the next few months, we will be very much at a place where the Fed might feel comfortable backing away.
And ultimately, if we shave too much of inflation off again, it's not necessarily our forecast, we're just discussing the scenarios. If we shave too much inflation out between now and yearend, the market is going to actually prove the Fed wrong on the Fed's own forecasts that they won't be cutting rates next year, they won't be doing QE next year, because it's going to look like they overdid it if you go into the end of the year.
Two comments we got out of Fed officials today, Kashkari who's suddenly has become the most hawkish member of the FOMC said, even after looking at today's data, which I'm not sure they've analyzed as closely as we have here at 42Macro, but if you're just looking at the headline, he was looking at the headline and says, I haven't seen anything that changes his view that they need to get rates to more or less 4% by the end of the year and continue hiking into next year.
Same story with Charles Evans, the Federal Reserve President out of the Federal Reserve Bank of Chicago. So, the Fed could very easily, like if you continue to play this forward, there is a legitimate plausible path to not only a soft landing, but to an actual Fed pivot, where they're supplying the market with liquidity in three to six months. And I think that probability has gone from basically zero two months ago to something that's probably gun to my head, 25%, 33%.
ANDREAS STENO LARSEN: If we take the market reaction at face value, it seems as if the market couldn't care less about these Fed speakers at the moment. So, if we assume that we're currently trading the data only and not the Fed speakers, Weston, which datapoints would you be on the watch for over the coming month two in your trading perspective?
WESTON NAKAMURA: Cross asset wise, just to pick up on what Darius said about Evans, he also said that the markets are pricing in monetary policy credibility over concerns of central banks will go too far. But again, like I said, as we were talking about, Powell essentially has killed off this concept of guidance and all that thing, so I don't know why they go out doing these speaking engagements in the first place.
So, yeah, in terms of markets, something that I actually would like to get your view on, either of you, is the 2s 10s curve on the US Treasury market, and the fact that it's off of that minus 50 basis points level, and you had some volatility moving around today. But that's still pretty deeply inverted. What do you guys think of that in the framework of a soft landing?
DARIUS DALE: Andreas, you want to take it first?
ANDREAS STENO LARSEN: Yeah. Until a couple of weeks ago, I actually thought that this inversion could go even deeper, because I envisaged a 1970s scenario where we had 2s 10s inverting to levels below 100 basis points, basically. And right now, I think the chance of a resteepening of the yield curve has increased alongside what Darius just mentioned on