Tuesday Morning Reads

The market is expecting Q2 to be the show-me quarter for economic data, where the numbers confirm the substantial economic progress baked into the run-up for the S&P (NYSEARCA:SPY) to record levels. But Wall Street is also concerned about an unwelcome side-effect of the comeback: a jump in inflation.

The Labor Department will release the March consumer price index at 8:30 AM ET, with a big rise expected in the annual headline number. Economists expect the CPI to rise 0.5% for the month, with the core CPI, ex food and energy, up 0.2%, both 0.1 percentage point higher than February. Year over year, the CPI is forecast to be 2.5%, up from 1.7%, with the core rate at 1.5%, up from 1.3%.

Economists say that inflation numbers are expected to have a kind of sticker-shock effect in the coming months because of base effects. The year-over-year numbers will appear to be large because the comparable 2020 months were at the heart of the economic shutdown.

There are also fundamental concerns, though, with supplier demand outstripping supply, as seen in the ISM numbers, heightening concerns about bottlenecks, that, and pent-up demand for services, could find its way into retail prices.

The March PPI raised some eyebrows last week. Wholesale prices jumped 1%, double expectations, while the Core PPI rose 0.7%, well above the consensus of 0.2%. The headline annual wholesale inflation rate hit 4.2%. ”This is beyond the base effects,” Allianz adviser Mohamed El-Erian said after the report. “This is something between demand pull and cost push and its something to pay attention to.” ”The ever rising cost of product procurement” is showing up in government numbers, Peter Boockvar of Bleakley Advisory Group says. “The y/o/y jump ... is more than base effect as the m/o/m numbers are up sharply too.” That said, the stock and bond markets settled down quickly after an initial reaction to the PPI report.

Controlling the narrative: The Federal Reserve has been keen to tamp down these inflation worries, stressing that the upward pressure on prices would be “transitory”. Also, the White House Council of Economic Advisers published a blog yesterday to deliver the "transitory" message.

Fed speakers have also been at pains to remind the market of its new policy to let inflation run hot for a time to balance persistent inflation below its 2% target.

Fed chief Jay Powell said in his weekend interview that inflation would need to be above 2% for a time, Vice Chairman Richard Clarida said the FOMC would need to see inflation above 2% for "at least a year" to change policy and Dallas Fed President Robert Kaplan says inflation could top 2.5% before settling down.

And the Fed is coming out in force after the CPI to hammer the message home. Four FOMC officials are scheduled to speak today. "Economists and the Fed in general will be less concerned about inflation than the market is,” El-Erian said. The Fed is cognizant that it needs to keep Treasury yields in check on the long end of the curve or risk facing another taper tantrum that would require more aggressive measures like yield curve control.

Of late, the 10-year Treasury yield hasn't seen the sharp moves that took it up to 1.75%. It's up 2 basis points this morning to 1.69% (NYSEARCA:TBT) (NASDAQ:TLT). But the trend could still be up.

”We've seen the initial rate adjustment with the 10 yr yield moving up 75 bps year to date,” Boockvar tweeted. “Once people realize what we're seeing is not so transitory, you'll get another leg up.”

Selling a dead parrot? Market inflation expectations are elevated. The 5-year breakeven rate, the difference between nominal and real Treasury yields, is at decade highs around 2.5%. The 10-year breakeven is at levels not seen since 2013 at around 2.3%.

But while inflation expectations are up, inflation “not so much,” according to David Kotok, CIO at Cumberland Advisors. Looking at the gap in nonfarm payrolls compared to February 2020, down about 10M jobs, and also the years of lives lost due to COVID, there is a “big chunk of aggregate demand” that has to be refilled and inflation pressures won't show up until the second half of this decade, he told Bloomberg.

”The market isn't afraid of inflation, this good inflation, this is reflation,” Brian Weinstein, Morgan Stanley Investment Management head of global fixed income, said.

Macquarie analyst Viktor Shvets likens the current concerns about stimulus and rebounding employment-boosting inflation (Phillips Curve) to the expired Norwegian Blue in Monty Python's Dead Parrot Sketch.

Economics “as a profession seems to be stuck with a dead or non-existent parrot, refusing to accept that unlike 1950s-60s, there are no longer any meaningful trade-offs between inflation, wages and unemployment, and that it is next to impossible to estimate capacity constraints,” Shvets wrote in a note.

”We do not anticipate that an inflationary pick-up (mostly due to base effect, demand normalization and supply bottlenecks) would be sustainable, and cheap global products (from textiles to mobile phones, and from batteries to cars) would still be available to the US consumers,” he added. “The peak of inflationary and reflationary momentum should pass by the middle of 2022 (Q2).” The peak of headline U.S. CPI is likely to be around 3%, he predicts. (11 comments)