Disorderly Markets are Getting an Intervention...
Revisiting Goldman's Macro 3D's, The BoE steps forward as gilts and sterling whipsaw, Goldman doesn't (fully) back down on their oil expectations, and more...
Welcome back to Market Making, your weekly dose of sell-side research and insight.
⏱️ Estimated Read Time: ~26min
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Part 1: Revisiting the 3D’s of Macro…
When I first began at Goldman, frequent debates on the desk surrounded the 3D’s of Macro: divergence, deleveraging, and deflation.
The 3D’s represent a negative feedback loop which, when it gets going, can exacerbate differences between the US and the Rest of World (RoW). Here’s how it works:
When the US raises rates above all other major trading blocs this divergence pushes up the USD relative to other crosses. Since so much of the RoW trades in USD or has USD-denominated debt, whether on the corporate or sovereign side, dollar strength then begins to crimp RoW growth and causes forced deleveraging action. This deleveraging takes the form of commodity price declines in USD terms, as they’re traded mostly in USD, and the attempt by foreign USD debt holders to de-lever as much as possible (given how much more relatively expensive it is to finance those debt holdings with their local currency). This deleveraging then causes the US to import deflationary pressure due to a tandem of lower commodity prices and cheaper US imports, which improves US real (nominal - inflation) incomes and, in turn, reinforces the rationale for higher US rates.
Note: To be clear, here’s why this theory is self-reinforcing: lower commodity and import prices juice economic growth in the US - all else being equal - which then leads to labor market tightness that feeds into real wage inflation. However, the deflationary pressures coming from commodity and import prices are often not enough to keep inflation below target. In other words, lower commodity and import prices can lead to an overheating economy with real wages that are too hot and inflation that is lower than it otherwise would be, without the deflationary pressures, but that still gets above target. Indeed, even if inflation is roughly at target - due to it being suppressed by deflationary pressures - if real wages are far outpacing the nominal inflation level then that will be an impetus for raising rates by the Fed, as the economy will be at risk of overheating and the Fed will be concerned about inflation rearing its head in future quarters due to the higher levels of disposal income consumers have from their real wage gains (this is commonly seen late in economic cycles).
Anyway, here’s one way to see all of this playing out today. In USD terms, Goldman’s commodities index is up 22% YTD which puts it inline with where it was prior to the invasion of Ukraine. However, the index denominated in Japanese Yen is up 51%.
Look at the chart below produced by GS — this is what monetary policy divergence looks like and what this divergence leads to: deleveraging of the RoW, which, in turn, imports deflationary pressure to the US.
And here’s the driver of that feedback loop of increasing divergence, the USD trade-weighted-index nearing highs not seen since the Plaza Accord.
Importantly, what I’m saying above shouldn’t be construed as me suggesting that US inflationary pressures will albeit precipitately due to this feedback cycle. This will likely be the case when it comes to commodity and import prices, but those are just parts of the inflationary puzzle (and we’ve already seen large deflationary pressures from these areas already — that’s largely why headline CPI is down from its peak!).
The little mental framework I’d use for thinking about US inflation today is that it’s composed of two factors:
Inflationary (or deflationary) pressures that are directly influenced by the 3Ds, which include commodity prices and import prices.
Inflationary (or deflationary) pressures that are derived from a tight domestic labor market and the high wage pressures that stem from it.
This strikes me as a reasonable mental model that is largely playing out as you’d expect. While the sharp acceleration in inflation that we say through the first seven months of 2022 in the US was mostly driven by commodity and import prices, sharp reversals in those has led to us coming off peak inflation (in particular, in headline CPI).
However, what has spooked the market over the past month is how sticky core inflation appears to be when the market’s original expectation was that we’d have a sharp, persistent drop in both headline and core that’d get us back to around target inflation (2%) by the end of 2023.
But this is because many are ignoring how most inflationary pressure - especially when it comes to services, which is the primary part of core inflation - will be influenced by the personal income levels of consumers. And if the average consumer is seeing their wages go up by 6.7% YoY then it’s impossible to think that we can miraculously fall back down to target inflation without labor market conditions deteriorating significantly from here.
Note: Wage growth has plateaued, but not fallen, over the past few months and while personal income isn’t entirely made up of wages (it’s slightly over half), historically wage growth has only been able to run 150-200bps above target before inflation rises above the target level.
This is the truth that the Fed tried so desperately not to explicitly articulate throughout most of 2022 (since it’s never politically popular to say you need to introduce labor market slack to get the inflation rate truly back to target).
However, after seeing the market not get the hint, the Fed has finally made it explicit: the unemployment rate is going to have to go up to get inflation down, because there is no way for wage pressures be significantly above the target inflation rate and have the inflation rate then fall towards its target.
This was something articulated by Governor Bailey of the BoE a few months ago as well. Although he took a somewhat less artful tact by saying that individuals shouldn’t request a big pay raise if they want the inflation rate to fall. While axiomatically true from an economic perspective, it’s not exactly something that goes over well with the general public!
On Friday of this week, core PCE for August also came in up 0.3% M/M (beating expectations of 0.1%) and personal spending up 0.4% (beating expectations of 0.2%). Thus illustrating not only a level of stickiness to inflation, but also that in the face of an inflationary environment consumers will lower their savings rate to maintain their spending.