Morning Notes — CPI

The sharp reversal in equity markets follows details that reveal the elevated CPI print came largely from stickier components like Owner’s Equivalent Rent.

OER: One of the biggest sources of inflation in today’s hotter CPI report was Owners’ Equivalent Rent (OER), which increased +0.8% MoM, the largest monthly increase in that index since June 1990.  OER is the single largest component of CPI at 24.25% and largely calculated through a survey question that asks ‘If someone was to rent your home today, how much do you think it cost them without furniture and utilities?’ Maybe this helps explain why the lag in OER has historically been the longest of all CPI components. Higher-frequency indicators on housing including reports from Redfin, Realtor.com and Zillow point to a cooling in September rent inflation. Recall a recent SF Fed study that estimated 50% of home and rental price gains since the pandemic resulted from a remote work demand surge.

Real yields: The narrative has been strongly in favor of higher real yields, which is what the Fed has been trying to achieve to slow the economy/inflation. Real yields across all maturities moved into positive territory nearly a month ago, which is likely when Fed officials began to privately contemplate an eventual pause in rate hikes.  People who think that inflation is entrenched should look at the implied CPI curve, where 1-year/1-year CPI is ~2.70.  This is slightly above the Fed target of ~2.30-2.40 but much closer than where it was 3-4 months ago.  Outside of housing, other high-frequency inflation data including freight, container rates and the Manheim Index have already rolled over. Unfortunately, the Fed faces far less political scrutiny if they focus on inflation rather than growth, and we don’t expect a pause in rate hikes until core CPI decelerates to something in the +0.20-0.30% MoM range.

SPX: Today’s rally in the S&P 500 (SPX) came after the index dipped below strong technical support at 3500 before reversing.  Capitulation-driven selling that takes intraday levels briefly below support is the second ‘buy’ signal after momentum dispersion triggers from October 3.  Our only concern is that today’s reversal comes despite a ~23bp increase in terminal rate expectations to 4.86%. Equities and terminal rate expectations have had a strong inverse correlation since May and today’s uncoupling deserves attention. Equities are also being driven by bond yields and their associated volatility. Today’s back up in yields and increased volatility (MOVE Index) is another reason to proceed with caution when adding equity exposure. The situation in the UK and the potential for another fiscal spending revision from PM Truss could be the missing piece, but it’s more likely for the situation to remain unresolved until the November 3 BOE meeting.