Here Is The Simplest Reason Why The Reflation Trade Is About To Fizzle
Forget Trump, forget China, forget oil, forget central banks unwinding their balance sheets, forget Reuters trial balloons: there is a far simpler reason why the ‘reflation trade’ is about to hit a major pothole.
Back in October, when the “credible” media gave Trump about 5% odds of becoming president and when there was approximately $12 trillion in negative yielding bonds around the globe, we said inflation was about to spike for a very simple reason: energy prices were about to anniversary their multi-year lows, and as a result of the base effect, headline CPI would surge dramatically around the globe for the next 6 months. It did just that, in many cases spilling over into core CPI, and in other cases confusing central bankers and traders into believing that inflation had returned.
Now it’s time for the hangover.
As SocGen writes in previewing tomorrow’s Headline and Core PCE deflators numbers, after spending nearly five years missing to the downside on the inflation target, the Fed finally achieved its goal as the yoy headline PCE deflator hit 2.1% in February. Unfortunately, Fed officials cannot take a victory lap, because they will be right back to missing the target again when the March figures are released. The data in hand from the PPI and CPI suggest that the headline PCE deflator likely fell by 0.164% in March, which would result in the yoy rate falling from 2.1% to 1.9% (1.885% un-rounded).
Energy prices – now virtually unchanged from a year ago – in the CPI fell by 3.2% last month, and these likely flowed through into the PCE as well. However, given the smaller weight of energy in the PCE gauge, the drop in energy prices will result in a smaller drag on the headline PCE index (almost a tenth less than in the CPI). Meanwhile, the CPI’s food index increased by 0.34% in March (that being said, the PCE food index is broader, and the food indexes in the PCE not present in the CPI have been a bit volatile of late).
So aside from anniversarying the unchanged Y/Y base effect, here is what else SocGen expects from tomorrow’s anti-reflationary PCE prints: the core PCE deflator looks to have declined by 0.1% in March (-0.072% un-rounded). A reading in line with our forecast would lead the yoy core rate to fall from 1.8% in February to 1.6% in March, which would be the weakest print in nine months.
It’s not just energy however: recall that one of the biggest drivers behind the CPI miss earlier this month was the sharp drop in wireless telecom services in the CPI, which will now flow into the PCE and subtract around 0.075 percentage points (pp) from the monthly change in the core PCE (which is less than the 0.15 pp drag in the core CPI given the lower weight of this index in the core PCE). In other words, the core PCE would have been flat if not for the wireless telecom services index.
Offsetting some of this drag will be a positive contribution from health care. Data from the PPI suggests that the health care index may have advanced by around 0.2% last month, marking its biggest rise in five months. Data within the Q1 GDP report suggests that the gain may be closer to 0.3% in March. In any case, core services prices in March look to have been essentially unchanged, while core goods prices may have fallen by 0.3%.
It goes without saying that the implications for the reflation trade – and for continued hawkish central bank sentiment – absent a sharp rebound in the price of oil in the coming weeks, are broadly negative.