Might Hotter Weather Bring Hotter Inflation?

Steve Sosnick, chief strategist, is joined by Jose Torres, senior economist, and Joe Burke, head of fixed income.  They discuss the July employment report, the ramifications of the 2-10 inversion, and how hotter weather might be affecting gasoline prices, utility expenditures, and thus consumers’ finances.

Summary – IBKR Podcasts Ep. 97

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Steve Sosnick

Hi everybody, welcome to the latest edition of IBKR podcasts. I’m your host today, Steve Sosnick, chief strategist here at Interactive Brokers, and I’m joined today by my 2 colleagues, Jose Torres, senior economist.

Jose Torres

Hello, Steve. Great to be here.

Steve Sosnick

Hi, Jose.  And my longtime colleague Joe Burke, head of fixed income here at Interactive Brokers. Good afternoon.

Joe Burke

Good afternoon, Steve.

Steve Sosnick

Thanks Joe. Let’s jump right into it.  I’m going to start with Jose because we’re taping this on the Monday after the July employment numbers.  Jose: Employment Report, Payrolls report, Good, bad or some of each?

Jose Torres

Definitely mixed. You had job growth slow pretty significantly from the past few months. You had the job gains concentrated in non-cyclical areas like healthcare, education and government; while the more cyclical areas, like leisure and hospitality, which were hot for a long time, cooled down pretty significantly. Manufacturing cooled, construction cooled, so we had a little bit of a mix of there. Now as far as inflation, you had wages gain above 0.4%, and that is inconsistent with the Fed’s 2% target. So, still some work to do there. The unemployment rate dropped, driven by a drop in labor force participation for prime age workers and employers to hedge rising wage pressures. What they did was actually reduced hours.  That’s sort of the dynamic that we’re in. Overall, no recession right now, but inflation still a very real risk.

Steve Sosnick

Well, more pay for fewer hours worked doesn’t sound like a bad thing for a lot of people. But yeah, that was my take immediately.  Share if yours is different, Joe.   There’s good and bad in here and you know people will read into it what they want to, I guess.

Joe Burke

Yeah, I think that’s right.

Steve Sosnick

Well, for the next one I’m going to move over to you, Joe.  Regarding last week’s bond market moves, which were quite substantial: do you attribute them mostly to the increased size of the of the Federal government’s refunding needs, meaning increased supply; the Fitch downgrade; or some of each? Where do you lean on that one?

Joe Burke

Yeah, I think that the supply is an issue. I think that definitely caused some of the market back-up, but I’m not sure that Fitch had much to do with it. I think people sort of saw that that as somewhat irrelevant. A couple of things that I think happened that were important are that Goldman and Bank of America basically suggested we’re going to have a soft landing.  That meant that the recessionary fears would go away. So, the curve starts to normalize a little bit. The other side is something that I’ve been hearing a little bit more recently this week, that the price of oil has been going up for several weeks now. And there’s some concern that that will get picked up as increased gas prices in CPI later this week. I’m hearing from others in the market that there’s some fear about that and that could cause the rates to go higher.

Steve Sosnick

One of the features of this move that we’ve seen over the past couple of weeks is that it has flattened out the 2-10 inversion, but it was effectively a bear steepener.

Joe Burke

Right.

Steve Sosnick

Which I think are pretty unusual. Can you explain a little bit more about bear steepeners and when we see them and what they may portend?

Joe Burke

A bear steepener is when the longer end rates rise faster than shorter end rates. And again, I think the expectations of a soft landing allow the longer end of the curve to back up further.

We don’t see them very often, to your point, but I think in addition, the expectations show no easing in the near future and that higher rates are going to be here for quite a while.

Steve Sosnick

And that leads into the next question, which references something I’ll hopefully be able to post along with the podcast.  I sent each of you a chart which I actually included in the piece that I wrote today, Monday.  It was a 30-Year monthly chart of the of the spread between 2s and 10s.  We see on the chart that after each of the inversions, when the 2-year yield exceeded the 10-year yield, we were pretty much almost always followed by inflation. There was one head fake in the late 90s, but since then it’s been a perfect predictor.  But the interesting part is that the recession, as defined by NBER, didn’t start until the curve normalized. Should we be excited by the fact that the inversion is shrinking, or should that make us more nervous?  And I’ll leave it to either of you to answer

Joe Burke

I mean, from my perspective, I think as long as employment remains strong, I think that the likelihood of recession concerns kind of goes away. The consumer is still spending; I’m not seeing anything troubling.

Jose Torres

So, we haven’t seen a bear steepener in a long time and part of that is driven because we haven’t seen inflation in such a long time, right? And what are bond buyers examining here when they take on this 10-year risk?   What’s going to be their return in excess of inflation?  And we’ve been talking about forecasting a bear steepener for a while in the biweekly weekly updates to the IBKR Economic Landscape. Entering an inflationary regime between 3½% and 4 ½% is supportive of a higher than what we’re used to 10-year rate.   At the same time, you have banks preserving their cash due of course to higher short term rates and the regional banking debacle that occurred in March; and you have the Fed backing away as well through quantitative tightening.  So, who’s going to be that incremental buyer over the medium to long-term of treasury bonds at yields close to the inflation rate?  I think that we’re going to be in a higher for longer yield environment.

Steve Sosnick

Joe, does that have any implication for TIPS? I know the TIPS yield is relatively high, and I’m kind of throwing this out at you from left field.

Joe Burke

Yeah, I haven’t really thought about TIPS very much, but yeah, there is potentially a lot more downside there or upside yield.

Steve Sosnick

OK that that does pose a bit of risk for inflation hedgers using TIPS then, right?  Speaking of inflation, Jose this week we have inflation reports.  You know, the employment numbers came out at 8:30 on Friday, and by 8:32 people’s focus had pretty much shifted to CPI and PPI coming over this week. What are your opinions or your projections for these numbers going forward?

Jose Torres

Well, Wall Street is very optimistic about these numbers. They’re expecting 0.2% month over month on both readings. I’m actually expecting 0.3% for CPI and 0.3% for PPI as well, and I think it’s driven mainly by the commodity story which is geopolitically sensitive. You’ve had some droughts in the Midwest, you’ve had some uncertainty related to El Nino. You’ve had the port blockade in Ukraine, you had the Saudis and the Russians colluding to cut oil production to keep those prices high, which benefits to those economies?   Thus, commodities rose about 8% in the month of July. Food and oil mainly. Now when we talk about services, labor market wages increased 0.4% month over month in the jobs report.  I’m expecting some of that to filter into the CPI as well.  Used automobiles are going to provide some relief. The relief from shelter costs is going to be a lot later.  I think a lot of the economists have made the mistake of thinking that new rents reflect all rents, and while new rents are slipping, most people don’t move every year. Most people have expectations to stay.  For landlords, their maintenance costs are going up, their insurance costs are going up, and if they have variable mortgages those are going up.   So, tenants that are still there want to stay. Landlords are increasing those rents and I don’t think that this report is going to be 0.2% on Thursday.  It’s going to be higher and may even put back the question of a live September meeting. I know the odds right now are pretty low at around 20%, but if we get hot numbers this month and next month, then I think we might see a 25 bp hike in September.

Steve Sosnick

Another interesting thing is, I think most people know that the Fed focuses on the core, but for most people, their number one inflation signal is basically the price at the pump. And I do think there’s been some pressure on that.  Gasoline prices have risen faster than crude because it’s underappreciated that refineries must slow down if the temperature is above 95 degrees Fahrenheit. As a result, I think that’s putting pressure on refined products, and we’ll see if that spills back into consumer sentiment. Another thing which I would love to throw out for discussion is this.  I have a theory that may be a little bit wacky, and I’m going to try it out on you two.  I think the heat waves are a real headwind.  The reason being, you’ve got 80 million people dealing with hotter weather in the US than they’ve ever had to.  In some cases, it’s 95 degrees at 2:00 in the morning. So, your air conditioner, if you live in one of these states, is running 24/7 and you may not even get the relief you need, but you have to do it basically to survive. And we also learned in a survey – I think it was a I think it was a Bloomberg Morning Consult survey – that only 46% of Americans can meet a $400.00 unexpected expense.  And I’d have to believe utility bills are that. Anecdotally, I spoke to a friend of mine in Houston, and she said her bill was up about $200.00 over the record high last month. What does this do for consumers? What does this do for spending, and can that be a real recessionary input or recessionary influence?  I’m not going to say you’re lighting the money on fire –it’s the opposite — but you’re basically using that money to finance utilities, not any sort of spending that you really want to do. I’ll throw this open to either of you.  Does it hold water and tell me if you think I’m insane and it doesn’t.  Tell me that please.

Joe Burke

Yeah, I think it’s a headwind for sure. The only saving grace, if you will, is that the season is relatively short. So come September, you know we’re going to turn off the air conditioners. But you’re right. It’s another expense. It’s like higher gas prices. It’s additional utility expenditures. And it’s got to cut into consumer spending at some point.

Steve Sosnick

And if you agree, Jose, what are the ramifications for that in the in the numbers you keep an eye on?

Jose Torres

Well, I think we’ve had a tale of two consumers. We’ve had the mid- to high-end consumer that refinanced their mortgage in 2020-21 who has a lot of savings or a 401K that is doing well this year, recovering from last year.   And then you have the working-class, lower-income cohorts who are feeling it pretty severely in all aspects of their budget.  I think that to the extent that the high-end consumer can continue spending things will be all right. But I do think that later in the beginning of next year, they’re going to slip up. You have some headwinds coming up like the student loan repayments, or the Redbook retail sales. It’s a really ugly chart, and it reflects mainly goods, but still. To our point earlier on rate sensitivity and the amount of stimulus that was unleashed: much of it helped corporate balance sheets with a lot of that refinancing, but it happened that a lot of the savings that occurred on their households really made it where the weakness from the rate sensitive sectors, like manufacturing and real estate, takes a lot longer to transition to the overall economy.  And that’s why I think that everyone is so perplexed on the street. When is the recession coming? We all feel like at some point it’s gonna come. We’re just early so many times. 

And let’s finish with a few anecdotes. Steve, just last month my A/C went out.  At the Interactive Brokers’ Florida party, we were on a boat and there was outdoor option or indoor option. I chose the indoor option.  The A/C there went off as well, and then at the gymnasium at Lifetime Fitness, a publicly traded company, the A/C also went off.  So, I’ve had a pretty personally negative experience when it comes to A/Cs, and they’re totally absolutely needed when it’s hot. So yeah, we have to keep that on.

Steve Sosnick

For those of you who don’t know, Jose is based in our Florida office and what it means is when I see you next, hopefully it’ll be in cooler weather, so you don’t have to be the A/C jinx.

On that note, I think we’re going to wrap it up for today. Thank you so much for joining us. My guests today, as I mentioned, have been Jose Torres, our senior economist, Joe Burke, our head of fixed income. I’m Steve Sosnick, chief strategist here at Interactive Brokers. And thanks once again for tuning in to IBKR podcasts, which can be found, well, you’ve already found us, at ibkrcampus.com, at ibkrpodcasts.com, and at all the various places you might find a podcast. Thank you everybody.