The US government will change its CPI methodology beginning next month. Previously they had updated weights biennially using two years of expenditure data. So for last year, the 2019 and 2020 y/y %’s have been combined to form the “comp” against which y/y inflation has been reported in 2022. 2019 and 2020 y/y CPI %’s were low.
Beginning next month, the US government will begin reporting y/y CPI comparing ONLY against the 2021 comps. As you know, the comps get MEANINGFULLY higher than the combined 2019-20 comps.
Source: BLS. As of 1/13/2023.
The US government is changing inflation methodology in a manner that appears to meaningfully step up the year-ago comparison – which means, even if nothing else changes, reported y/y CPI inflation should fall dramatically in 2023. This could give a political cover to the Fed to pivot policy as the appearance of lower inflation will take hold of the numbers. Is this the change in inflation policy (i.e., move inflation target higher) we predicted back in Q4 ’22, just in a more subtle way?
This is very recent news and we are still digging in to the implications ourselves. We will be back with a more detailed note in the coming weeks.
Japan Maintains Yield Curve Control (YCC) at 50bps
We believe Japan is another potential pressure on longer duration US Treasuries. The Bank of Japan (BOJ) notably moved the ceiling on their long-implemented Yield Curve Control (YCC) back about a month ago from 25bps to 50bps. What exactly does this mean? Well, as yields rise above the ceiling, the Japanese Central Bank buys the bonds (i.e. the whole point of yield curve control is to control the level of rates).
Source: Bianco. As of 1/13/23.
How does the BOJ buy the JGBs (Japanese Government Bonds)? They have two options: print their own currency or sell their war chest of US Treasuries. We believe this selling pressure could continue to elevate yields on the longer end of the UST curve (i.e., Treasury notes). With both the Fed out of the market and Japan (historically one of the largest buyers of US Government debt) out of the picture, we believe that, historically, the attractiveness of long duration bonds is much less certain even in a recessionary environment.
The Risk of An Early Pivot
Policy tools are blunt, and the path toward equilibrium is likely to be volatile. Typically, the first move is to tighten to fight inflation at a time when growth is strong (Fed started too late). Once growth has been reigned in and inflation is in a downtrend, the tendency is to pause and see how things turn out. The pause tends to trigger a sharp relief rally in assets, which supports the economy, which cuts short the decline in inflation, requiring a second round of tightening.
These pauses generally weaken the currency as well, adding yet another inflationary pressure that increases the odds of further tightening. Pair that with the second largest economy in the world reopening and you could have the gasoline needed to continue to provoke the inflationary fire. In the ’70s, most countries required three rounds of tightening.
2022 QT Was Fairly Insignificant In % Terms
The Fed reduced its balance sheet by a measly 2.4% in 2022. QT should continue in the background at $95bn a month (although it’s closer to $80bn in reality, thanks to mortgage prepays slowing drastically).
Source: Bilello. As of 1/06/23.
We would expect the Fed to pivot their QT policy before they pivot their rate policy. Stay tuned to see how the Fed’s balance sheet plays out in 2023.
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