The Inflation Situation

The Inflation Situation

Posted On November 18, 2022 2:30 pm

We know the Federal Reserve and other Central Banks have made fighting inflation their number one priority. However, there is growing evidence that not only has inflation peaked, but we have already entered a period of disinflation and are rapidly moving towards a period of deflation.

What’s interesting is that both bulls and bears point to this as a reason to bolster their own cases. This kinda speaks to why Options360 established a form of straddle on SPY yesterday through a double diagonal trade. Rather than get too opinionated or dogmatic, we keep an open mind and use the flexibility of options to trade what the market gives us.

For the bears, deflation would be a sign the economy is heading into recession. For bulls, it would provide credence to the Fed pivot they’ve been predicting for the past few months, which would relieve the pressure on stocks prices.

Another item both bulls and bears seem to agree on is just as the Fed stuck with their belief inflation was ‘transitory’ and was way, way too late to act, it will now stick with a hiking policy that lasts too long.

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The Wrong Policy Tool

Before getting to the evidence the Fed might once again be ignoring what seems obvious to people who live outside the ivory tower and track markets in real time, let’s briefly address a fundamental problem with Fed policy.

Namely, they are raising interest rates to target the labor market in terms of both unemployment levels, which they want higher, and wages, which they want lower. To most people, this not only seems cruel, but nonsensical.

Given higher rates can do nothing to alleviate the supply chain side of inflation, which some peg at over 50% of the cause for increase, they are flirting with creating a situation of stagflation. Stagflation, which is an environment of low demand but still high inflation, the worst of both worlds.

Luckily for us, the supply chain pressures look to be easing rapidly. Based on the Kansas City Fed’s Manufacturing Survey, supply chain stress evaporated in November as the outlook for supplier delivery times crashed to lowest on record.

Lag Time

However, Powell and crew seem to be ignoring this, as well as other real time prices, especially across commodity markets.

The price of everything from oil/gas, lumber ,and copper have all retreated some 50% from their highs. Other areas, such as shipping costs, have also plunged over the past two months. One area that seems sticky is food, particularly for grains such as corn and wheat; while prices for proteins such as beef, pork and chicken have been retreating.

And just as there will be a lag effect of some 6-8 months before we can assess exactly what impact the recent rate hikes will have on the economy, it will take some time before the above raw input costs work their way into finished goods.

It is starting to feel like while the Fed keeps acting on backward looking data such as CPI, their policy is on the wrong side of the equation. We will see the impact of this policy when higher rates and lower prices cross in the next few months.

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Housing Market Stuck, Not Sunk

The other item which seems to be getting misinterpreted is the state of the housing market.

It’s clear the market got overheated between 2020 and early 2022 and higher rates have cooled it considerably, however, we are nowhere near seeing a ‘crash’ in home prices like that of the 2007 housing crisis.

People keep pointing to steep decline in home sales activity, such as the chart below, as a sign there is an impending correction in home prices.

Existing home sales:

Yes, home sales have plunged and prices have moderated in some of the hottest markets, but you need to look at the reasons behind stalled activity.

Long story short, sales have come to a near halt, not because the market is collapsing, but because people are basically stuck.

For new buyers, homeownership has become unaffordable. The combination of the increase prices and mortgage rates have made monthly payments for the average home (around $385k, up from $280k in 2020) closer to $2,900, which implies the need to have an income over $120k per year to buy.

Existing homeowners that might want to upsize (or empty nesters looking to downsize) that have locked in sub 3.5% interest rates also can’t afford to sell, even if at a profit. Even a lateral move to a similarly priced home would cause a 45% increase in monthly payments due to higher mortgage rates.

Meaning, the market is not tumbling, it’s simply stuck. This may take a few years to see how it plays out, but for now, there’s simply too much equity built up, too little inventory, and solid demand for a broad and deep decline in home prices to occur.

And this might be the key to avoiding a steep drift into deflation and deep recession.

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About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.