ALFONSO PECCATIELLO: Hey everybody, welcome to the Real Vision Daily Briefing. It's Wednesday, January 12th, 2022. This is Alf, the author of The Macro Compass, and I'm here with the one and only Darius Dale, founder and CEO of 42Macro. Hey, mate, how are you doing?
DARIUS DALE: Good, man. It's good to have the dream team back, man. How are you doing?
ALFONSO PECCATIELLO: The dream team? Did you actually trademark that, or?
DARIUS DALE: No, someone else tweeted that earlier today, man. I'm paraphrasing.
ALFONSO PECCATIELLO: Cool, cool, cool. We can live with that, by the way. The news of the day is obviously CPI inflation in America, 7% year on year, higher spring, I guess in 40 years or so. Month on month core, to clean up a little bit of the noise, is 0.6%, which is still relatively robust but not growing anymore, incrementally month on month, real wages down as a result.
Nominal wages are up, but inflation is higher even more so real wages actually dropped. Market reaction, while yields are unimpressed, they're unchanged. Actually, 10 Year yields are down from the peak of 1.8%. They're hovering around 1.72%, 1.73%. The front end though is pricing almost four hikes by the Fed. Interestingly, the Eurodollar is rallying quite interesting, I would say.
And all the assets that were hammered down last week, the NASDAQ, Bitcoin actually start to overperform once again. And commodities, on the other hand, are still rallying. Quite a lot of stuff going on, we'll try to unpack for our listeners today. What do you think of the overall market reaction and the inflation print, Darius?
DARIUS DALE: Yeah, I thought the market reaction was you typically see this in micro investing with earnings and things like that, where there's a whisper number, if you will, on the buy side in terms of what investors are expecting, relative to what economists are expecting. And I think the biggest takeaway is that this trend didn't surprise to the upside, certainly not in a material fashion.
That's what took, I guess, some of the air out of the short bond reflation trade, if you will, and put some impetus back into the tech, NASDAQ type exposures. I think if you look at the report, there was a little something for everyone in the report. From a headline perspective, you're going to get the political narrative associated with 7% headline, that's obviously a big deal.
And then obviously, core CPI continuing to gather momentum, we have that tracking at a 7% on a seasonally adjusted annualized basis. That's a big deal. But on the other side, from a dovish perspective, and this is a leading indicator, you look at this SAR for most of the baskets, headline, food, energy, shelter, OER, non-durables, and even on a median basis, all those seasonally adjusted annualized rates tick down.
And I think the most important number of all those statistics is the median CPI rate, which slowed to 5% on a SAR basis. That's the lowest print we've seen in four months. All signs are pointing towards disinflation for 2022. We know that tradable goods inflation is going to disinflate at amount. The reality is, does the Fed understand how tight the labor market is with respect to the wage pressures that are meeting that process halfway?
ALFONSO PECCATIELLO: Wow, Darius, you just told the audience that basically, disinflation is upon us on a day where inflation has, on a nominal basis, CPI nominal headline basis, bring that 7% year-on-year. And you talked about a couple of elements in there, because we get sold a lot of these headlines where we look at inflation is 7%, or the month-on-month rate is very high that you decompose it a little bit further. Would you mind rewinding back for a bit just to make sure that people understand why do you think the impulse, the inflationary impulses into 2022 are about to slow down, not to increase?
DARIUS DALE: Yeah, absolutely. They're already slowing. We've been tracking a lot of the economic statistics throughout the pandemic on a seasonally adjusted annualized basis, so either month-on-month annualized, quarter-on-quarter annualized. Clearly, these are month-over-month statistics. And the one thing I call out is headline CPI not only decelerated on a seasonally adjusted annualized basis to 6%, that's the lowest print we've seen in three months, but that's down about 40% from where it peaked over in June of this year.
And the same thing with core inflation momentum, it's still down about 40%. Even though it ticked back up very narrowly, it's still down about 40% from where it peaked earlier this year. We're well past the peak in terms of impulse. And now, all we have to do is roll forward in time to the accumulate base effects that push the overall headline statistics down.
When you and I are not having these conversations six months from now, inflation will be likely fairly materially lower, but I don't believe that core and stickier parts of inflation like shelter, wages, things of that nature are going to move in a direction quickly enough for the Fed to back off of its tightening mandate.
ALFONSO PECCATIELLO: And the result of that basically that there are two key words Darius has used there, momentum and impulse. Because at the end of the day, it's easy to watch the inflation numbers, but what matters is not only the number itself, but the rate of change of the rate of change of the price of this basket of goods.
That's the impulse of this inflationary momentums, which are under the hood actually slowing down. The fixed income market, that actually agrees with that and has been agreeing with that for a while. I pulled up a chart from The Macro Compass newsletter I write to just pinpoint to that which is the slope of the US inflation breakeven curve. There will be basically 10-year inflation breakevens and two-year inflation breakevens, one against each other, and since around the first quarter of 2021, the market started expecting higher inflation in the short term, but not a sustainable one.
The curve actually inverted, which means investors expect 10-year inflation down the road to be actually lower than the short-term spike we're going to see for a couple of years. While the definition of transitory might be debatable, because what's transitory effectively, the fixed income market is telling you that long term inflationary pressures are going to reduce so as Darius was saying before, the impulse of these inflationary pressures is likely to decline going forward.
DARIUS DALE: Yeah, absolutely. And that's consistent with the Fed's forecasts, that's consistent with economist's consensus forecasts, and I do believe the Fed is well aware, this is always the Fed's plan all along, which is it was going to be transitory, it petered out. Certainly, a lot of us thought, myself included, it would peter out at a level lower than 7%, but the reality is that forecast is still intact.
The big issue in my opinion is going back to Friday's jobs report which continued to be incrementally hawkish with respect to the tightness in the labor market. And from our vantage point, it doesn't seem like the Fed has really caught on to that in full. It certainly seems like there's some upside surprise risk with respect to the hawkish contingency on the Fed and how hawkish they're willing to be throughout 2022 as a function of those labor market inflation dynamics.
ALFONSO PECCATIELLO: And Darius, another curve, which is actually getting closer and closer to inversion is the 5, 30s curve, so the slope of the curve between five-year and 30-year government bonds in America, which is flattening even further. Actually, let's listen in for a second to what Jared Dalian and Peter Atwater discussed on the Real Vision interview. They were effectively talking about the Fed and curve inversion. Let's listen in to what they said.
JARED DILLIAN: I think a lot of people are still operating under the assumption that the Fed is this dovish institution that is dominated by liberals and academics and they're going to keep rates at zero forever. I think the Fed is going to surprise to the upside in terms of the velocity of rate hikes. The market is pricing in about three and a half rate hikes for next year. I personally think four is a done deal. We could actually get more. I think Fed Funds are probably going to 2%. I think they're going to invert the curve a lot.
When I look ahead to 2022, just in terms of the Fed, once you invert the yield curve, then the clock starts ticking, and you have anywhere between zero and 18 months before you get a recession. Next year could be a lot more challenging. And I'm not just saying that reflexively as somebody who's skeptical or bearish all the time, but it's just the facts. The Fed is going to get more hawkish in 2022.
ALFONSO PECCATIELLO: Interesting remarks. The full interview is available for Real Vision subscribers all tiers. Now, Darius, Jared Dillian in the interview was talking about curve inversion, nominal curve inversion. He's basically depicting the Fed which is likely to be relatively hawkish and overreact effectively. Can you unpack a little bit if you think the curve is actually going to invert and why is that relevant in the first place for different asset classes, if that happens, or doesn't happen?
DARIUS DALE: Yeah. I'll take a step back before we even get into that. And I'll say, this is the second time today I've been showing up in shirts and shirt is outstanding. I don't know where I got it from but hat tip to that as a guy who fancy shirts. But getting back into the question, no, I don't think the Fed-- I think the Fed is well aware of this curve inversion dynamic.
And in my opinion, I think that's why they've been so slow foot or slow to react to these inflationary pressures in terms of their dotplot, in terms of their messaging and signaling. It's my expectation that as they get going with rate hikes, and we definitely agree with Jared, we actually made that call going back to the November jobs report, we got in early December, we said, hey, they're going to have to hike four times next year.
Because in terms of all the analysis we've been tracking in the labor market, that is consistent with the Fed's maximum inclusive mandate. We see two step functions higher in terms of the rate of improvement over the last couple of months. Four hikes is a done deal, and I think that's pretty clear and priced into the Eurodollars market.
The reality is, with respect to curve inversion, I do believe the quantitative tightening dynamic that theyve introduced into the markets going back to the December meeting but more importantly, the minutes over last week, that dynamic is what's likely to prevent curve inversion. It's very likely, I believe, that as we get into the rate hike process, and the curve starts to get flatter and flatter, we may see them introduce a program like Operation Twist, i.e., something we saw in 2011 to prevent curve inversion, or at least slow the rate of that decline. What are your thoughts on that?
ALFONSO PECCATIELLO: Yeah, well, actually, there's this elephant in the room, which is quantitative tightening. What are they going to do with the balance sheet? We can talk about hikes and if they hike three times or four times, but the reality is that the impact of balance sheet reductions, and especially as you were describing, how are they going to reduce the balance sheet? And what's the interconnection between that and the issuance pattern of the government?
Actually, that's going to play a pretty large role. And there's a lot of thought on the fact that quantitative tightening might be less hard than initially thought, because the plan according to a couple of hints Powell gave us seems to be that, yes, they want to proceed to reduce the balance sheet pretty quickly. Let's call it a trillion in 2021 maybe, just to shoot a number out there, we don't know exactly yet but perhaps it's likely.
But actually, the point is that they plan to collaborate with the US government that it's going to shift their issuance more towards the short end. And they're also going to make, let's say, make sure that the money trapped in the reverse repo facility is going to get used to absorb that increase deletions from the private sector. This seems to be a little bit of a workaround, Darius. But the reality is, how long can they work around balance sheet reduction without being kryptonite to risk assets?
DARIUS DALE: I don't think they can work around it well at all to be totally honest with you. And the reason I say that, is that, yes, there's let's call it $1.5 trillion of reverse repo looking for a more "permanent home", that's obviously in Treasury bills or something of that nature. And yes, the government can actually start to increase its issuance on that side of the curve in order to help that money find a home.
But the reality is we're moving in the wrong direction as it relates to supplying asset markets with liquidity. The Treasury General Account balance is now going up, it's bottomed and now heading up. The Federal Reserve balance sheet is now peaking, is likely to start to come down. And at the end of the day, those are two negative dynamics with respect to a US government that has to capitalize itself.
I say this all the time, the US government is at the top of the world's capital structure. It is the bullion playground. And when it needs cash, it gets its cash. And it's either getting it from the Fed, it's either getting it from the foreign official sector, foreign central banks, or it's getting it from us, and we have to capitalize the government. And we haven't had to capitalize the US government in a material rate since February 2020.
And now that we're going to have to start to capitalize the US government again, Uncle Sam, not just paying taxes, but actually getting the debt issuance taken down, that's going to be a problem for asset markets, because a lot of liquidity is just simply there from a regulatory standpoint.
ALFONSO PECCATIELLO: Yep, exactly. And I always want to make sure that our listeners understand that we get into these discussions about what's going to happen in 2022, and maybe in the first quarter, the second quarter. But what Darius just described as well fits into a more long-term narrative of what real interest rates can be and can trade on an equilibrium level.
Darius was saying, actually, if the private sector needs to absorb more supply of collateral, because reserves are going down into the system, out of the system because of quantitative tightening, and therefore it's the private sector that needs to be basically more involved in absorbing this issuance, then probably there's going to be the premium required in order for the private sector to step in. That premium is generally higher real yields, especially at the front end, where most of these institutional guys are involved.
We're talking about money markets, treasuries, corporates actually recycling their dollars into Treasury bills or short end. Now, the long end of the real yield market, though, seems to be pretty stubborn. If you look at 10 years down the road, 10, 30 Year real yields, they're pretty low, and they are not managing to get higher at all. And this is more the structural story. There are reasons why those don't go up.
It's because if you look at the total debt to GDP, including the private sector and the public sector in America, in Japan, in China, in Europe, or wherever you want to look at, you're ranging between 300% and 400%. The servicing costs are simply on a real basis unaffordable if long term real yields go up. I pulled up a chart again from The Macro Compass showing that structurally speaking, the trick of expanding credit and lowering real borrowing costs has been played in Japan and then in Europe with a bit of a lag, eight years in the chart, and then in the US as well with a bit of a lag but it's still the same game.
You borrow more, you expand credit, borrowing costs go down on a real basis because that's the new equilibrium to make all of this affordable. And that's how you kick the can down the road. So, while we focus on short term movements, let's always not forget that there is a structural background on the back, or do you think differently about this, Darius?
DARIUS DALE: No, I don't think differently about it at all. A lot of the key drivers of why interest rates and growth have been so low for such a long period of time, namely debt, namely demographics are the two main culprits, those haven't gone anywhere. In fact, they're obviously moving in the wrong-- they continue to move in the wrong direction. If you look at our fire-year forward curve for working age population growth, if you look at our five-year four curve for old age dependency ratio, those things are actually getting worse at the margins.
You can make the case that, and I will make the case that the bond market is smart enough to look through all these not only cyclical dynamics, but also shorter term, shorter duration dynamics with respect to the yield curve. The real issue, and this is something we've back tested as carefully as anyone, which is when you're doing quantitative tightening and you're doing it in a reflationary environment, that is negative for bonds.
The risk premium for bonds expands investors' need to demand that they need more yield, they need more return to hold that mature debt security in their asset in their portfolio mix. When the Fed is doing quantitative tightening in an inflation, that's stagflation for most of you, or in a deflation, that's where growth and inflation is slowing simultaneously, in those scenarios, bonds go up in price because the risk premium assigned to other asset classes, they start to get crowded out. And those risk premiums start to widen. That's effectively the reverse of exactly what's happened over the last 18 months or so, 20 months or so.
ALFONSO PECCATIELLO: Couldn't explain it any better. How does this play out in other asset classes? We're looking at the NASDAQ crawling back against more real economy or less valuation intensive sectors in the equity market. We're looking at Bitcoin rallying back, and we're also looking at some commodities staging a continuous rally like oil, for example. How does this play out in other asset classes then?
DARIUS DALE: Yeah, absolutely. I'll tweet out these charts, but I actually put together a quick analysis for everyone to understand what quantitative tightening means from a market risk perspective. Right now, we're in this reflation regime, the market is pricing in a positive impulse in growth and a positive impulse in inflation. That's the regime that the market is pricing in currently.
We do believe the next regime is likely to be a deflation regime, which is pricing in a negative impulse in growth and a negative impulse in inflation. And oh, by the way, that deflation regime is likely to coincide with quantitative tightening on a trending basis. Thinking about, let's look at this across asset classes, from the S&P 500 perspective, just using that as a broad measure of beta, when the Fed is quantitative tightening in reflation, that's the positive regime, your annualized expected return for