A Second Wave of Inflation is Already Underway (February 12, 2024)

Plus, Harley Bassman on how to bet on higher-for-longer interest rates

By Lisa Beilfuss

Upside inflation risks are reemerging, complicating monetary policy in a way many investors may not yet appreciate.

There has been a broad assumption that inflation will continue to descend from current levels–3.9% and 2.9%, annually and respectively, for the core consumer price and personal consumption expenditure indexes. But there is building evidence that such an assumption is flawed. Should inflation rise anew, economic data may reflect rising prices precisely when investors expect the Fed to begin cutting interest rates, creating headwinds for markets and the Fed alike.

Consider details of the Federal Reserve’s latest SLOOS, or senior loan officer opinion survey on bank lending. The consensus takeaway that bank lending remains tight isn’t wrong. But the details suggest the trend is shifting as bank lending in the latest quarter became significantly less tight versus recent quarters. Jim Reid of Deutsche Bank highlights credit standards for commercial and industrial loans, which tightened at their slowest pace in seven quarters. Lending standards for C&I loans to small firms leads GDP by two quarters, Reid says, noting that the latest data “represents a significant moderation of what had been the very negative SLOOS signal.”

What is more, credit standards lead wage growth by six-to-nine months, says Andreas Steno Larson, CEO of Steno Research. While loan demand is still “underwhelming,” he says credit demand lags credit supply and financial conditions by a quarter and predicts a rebound in loan demand during the second quarter.

“The SLOOS reveals that the U.S. economy is accelerating and that inflation risks are back,” Steno Larson says. “Inflation is likely going to return with a vengeance. If the Fed cuts in May, they will end up cutting straight into a cyclical upswing.”

Now consider what is happening in the background. A housing recovery has already started, says Apollo chief economist Torsten Sløk, as falling mortgage rates meet pent-up demand and low inventory. The S&P CoreLogic Case-Shiller Home Price Index has risen on a year-over-year basis in each of the past five months (the latest data are for November). It last rose 5.4% from a year earlier, the biggest year-over-year increase since November 2022. Housing comprises about 40% of the CPI and 25% of the PCE, with shelter inflation in those baskets lagging home-price changes by about a year.

Already, the three-month annualized core CPI has moved higher three months in a row. That metric bottomed in September at 2.96% and rose to 3.32% in December. Fed Chairman Jerome Powell emphasizes the so-called supercore CPI, which excludes shelter in addition to food and energy. It bottomed in October, rising from 3.70% then to 3.91% in December.

Regardless of whether energy prices are excluded from an inflation metric, such prices affect virtually all goods and services. The renewed CPI rise has been without energy prices contributing. But so far this month, crude oil has gained 5.7% while Brent crude has gained 5.4%. A breakout in energy prices here would not only underpin headline inflation momentum, but potentially push inflation expectations higher. Stable inflation expectations are crucial because price expectations influence behavior and can amount to a self-fulfilling prophecy.

“Expect to see inflation expectations starting to creep higher in upcoming surveys,” says DeLuc Trading’s Craig Shapiro, a development that could undermine the current narrative that the Fed is about to embark on normalization cuts because falling inflation means real, or inflation-adjusted rates, are more restrictive.

Praxis in the past week spoke with famed bond investor Harley Bassman, also known as the Convexity Maven. He says the bond market hasn’t been so disconnected from Fed policy in over 30 years. Bassman, for his part, believes inflation will remain elevated for longer than many investors think, and he sees just three rate cuts this year that don’t begin until July. Markets are pricing in 53% odds that the Fed cuts rates at least five times this year starting in May.

“We’re not there yet,” Bassman says about inflation figures. Moreover, he says, an unemployment rate still below 4% and a 3.4% GDP estimate from the Atlanta Fed’s GDPNow model aren’t numbers associated with falling inflation.

That is not to mention Powell’s potential concerns about his own legacy. “He does not want to be Arthur Burns,” says Bassman, referring to the former Fed chairman from 1970-78 blamed for cutting rates too soon and rekindling inflation. “Paul Volcker is thought of as a saint and Burns as then-President Richard Nixon’s lap dog. Powell wants to be remembered like Volcker,” Bassman says, referring to the Fed chair who followed Burns and choked inflation.

Bassman offers one way to bet on a higher-for-longer policy outcome: Buy newly issued, higher coupon mortgage bonds.

Mortgage-backed Securities (MBS) are the second largest bond asset class after U.S. Treasuries, and they are implicitly backed by the U.S. government because of government-sponsored entities like Fannie Mae. Historically, newly issued MBS yield roughly 75 basis points over 10-year U.S.Treasuries, and presently the spread is nearly double that amount.

Now managing partner at Simplify Asset Management, Bassman has created an exchange-traded fund for non-professional investors to directly own only newly issued MBS which currently yield about 5.75%. For more on the strategy, you can read more from Bassman here.

A higher-for-longer policy outcome assumes a familiar reaction function, where the Fed responds to above-target inflation with tighter policy. It is unclear whether and how factors including a new average inflation targeting framework, $2 trillion in global debt maturities this year, and a looming election will influence policy decisions. Regardless, investors should prepare for a renewed pickup in inflation that may become more evident in the coming months.