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Inflation analysis and its implications for the markets

In our analysis we focus on the latest inflation print and try to look under the hood, while we reveal a great opportunity.

Let´s start with numbers

On Tuesday, the new inflation print was received among the markets. Although it was merely very negative, and punished the markets, in our analysis we will look deeply into where the opportunity lies and what the market is currently pricing in.

Read also: How to mine cryptocurrencies in a bear market

According to our previous article (flash news):

In contrast to estimates of -0.1% monthly, headline CPI increased by 0.1% MoM. Inflation has been climbing for 27 months in a row. The annualized CPI fell to 8.3% from the projected 8.1% and 8.5% in July. the core number was 0.6% month-on-month as opposed to the 0.3% anticipated and 0.3% previously. As a result, the yearly core CPI increased to 6.3% versus the projected 6.1% and the 5.9% booked in July.

In the following chart, you can see the structure of headline CPI (MoM) as well as core CPI. Inflation is being driven by services, which experienced a strong rise after declining a month ago. The only trigger that dragged the headline down was energy, but CPI ended higher than expected due to services.

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CPI MoM Composition, Source: Cameron Dawson via Bloomberg

Why such a big miss in estimates? Because no one expected the most lagging component of inflation, shelter, to rise in such a manner and be such a significant contributor. It also has a positive weight in the CPI basket (even bigger in core CPI).

Related: S&P 500 drops like a rock after US inflation data

We’ve broken down what the MoM CPI (seasonally adjusted) would look like if we removed shelter from both the CPI and the core CPI. And as we stated above, headline CPI rose by +0.1%, CPI less shelter declined by -0.2%, and core CPI less shelter rose by 0.5% (a little bit down from 0.6%).

MoM Change in CPI compared to „less shelter“ item, Source: Investro analytics team

The implication – the rates

While shelter is the most lagging part of the also lagging CPI basket, this is the item of which the Fed is aware and wants to cool it down. However, it will undoubtedly fall because the Fed has already tightened monetary policy, but it takes time for it to reach the economy, and even more so the shelter segment. After such record monthly figures from core inflation, the market pricing of rates exploded as well as short-term bonds. However, the long end of the yield curve rose only slightly.

Fed Funds Futures Rate Dec/2022, Source: Investro analytics team via Tradingview

However, we believe a 100 bps hike to be very questionable, because it would be an absolute moat and cause a massive shock to an ill-prepared economy. The odds of the recession could absolutely increase just due to such a shock, so maybe the Fed will be aware of this and won’t deliver such an aggressive hike, but may aggressively reduce its assets from its balance sheet, thus doing a little bit more aggressive QT to affect the housing market.

Rate hikes odds, Source: Investing.com

Trading idea – Bullish on Bonds

We are even more bullish on bonds now as the short end of the yield curve has risen significantly. A great choice could be TLT or AGG, but AGG has a lower average maturity of its portfolio and thus could more closely match the following great chart. The charts below describe the development of yields before the Fed’s pivot and after it. A general rule in bonds is that when yields rise, the bond prices decline and vice versa. Thus, if you want to gain some exposure to bonds, it would be better to know when the market prices many rate hikes (till the end of 2022 as well as early 2023), as it is doing right now.

While many view this positioning as risky, we believe there is a great long-term risk/reward ratio, while we also believe that there is only limited room for further decline in selected bond ETFs.

Warning: The fully covered text is not investment or trading advice. It represents only the author’s point of view and thoughts, and we do not bear responsibility for your potential loss. The article serves only for analytical and marketing purposes.

Our Investro Analytics Team is made of financial experts and professionals who are creating content for you from all around the world. They do this by sharing their insights, ideas...

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