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The average market participant is more conscious of economic data than ever before, owing to the uncertainty and volatility we are seeing on a global level both financially and politically.
Due to the increasingly poignant impacts of new data releases from the US, as the Fed is now well underway in implementing its monetary tightening regime, the importance of understanding how to interpret the data and its implications for an investment portfolio has dramatically increased. Most actionable economic data comes out of the US, due to the global hegemony of the dollar.
In this article, we are going to delve into the mechanics of CPI and inflation data alongside how trading/investing with this in mind can have dramatic effects on your overall portfolio performance. Let’s dig in.
CPI, Core and PPI – The Key Barometers
Measuring and quantifying inflation in an actionable manner is a contentious task with many seeking alternative methodologies for attaining an accurate read on broad price changes in an economy.
The Consumer Price Index (CPI) is one of the most popular measures of both inflation and deflation. The CPI measures the change in prices paid by US consumers. The Bureau of Labor Statistics (BLS) calculates the CPI as a weighted average of prices for a basket of thousands of goods and services which represent aggregate consumer spending.
Core Inflation (Core) is calculated by taking the CPI and subtracting the most volatile items such as food and energy. In this way, Core is always a smaller value than CPI. The controversy around the use of Core as an accurate inflation metric stems from the notion that rising food and energy prices are more likely to materially impact the household budgets of all consumers. Due to this, less importance is generally placed on Core readings. However, with the current global supply shocks, we are seeing with energy and food, the Core readings have carried more importance in recent months, acting as a less noisy CPI.
Another metric for measuring inflation is the Producer Price Index (PPI), which measures changes in the prices received by US producers of goods and services. This is a measure of wholesale inflation as opposed to consumer inflation and is used in conjunction with CPI to get an accurate read on the wider economy.
In essence, if these gauges of inflation are rising too dramatically from a MoM % perspective, then inflation is out of control and the Fed must step in to prevent a catastrophic price spiral causing average consumers to suffer.
The dominant tools in the Fed’s arsenal for combating rising inflation are raising interest rates and reducing the size of their balance sheet by selling US Treasuries and Mortgage-Backed Securities (MBS) – this is known as quantitative tightening (QT) and is the inverse of Quantitative Easing (QE – money printing). Both interest rate rises and QT ultimately result in less availability of capital (M2) and liquidity in the financial system.
Interest Rates – The Important Lever
An interest rate is a measure of the cost of borrowing. If you’re a borrower, the interest rate is the amount you are charged for borrowing money, shown as a percentage of the total amount of the loan. The higher the percentage, the more you have to pay back, for a loan of a given size.
A small change in interest rates can have a large downstream impact on both consumers’ and businesses’ ability to borrow capital. By raising interest rates, a central bank reduces the quantity of borrowing in the economy, and the availability of capital, thereby slowing economic growth alongside many of the contributing hallmarks of inflation. As a direct result of this, financial markets take a battering in the face of rising interest rates as the price of money increases. This is the cause of the carnage we have seen thus far in 2022, especially for risk assets such as $BTC.
Figure 2 – A chart showing the relationship between $SPX and $BTC with the US CPI data. Annotated with key dates and data. Source – TradingView
Simply the mention of interest rate rises by the Fed in Q4 2021 signals the market top for risk assets and equities even before interest rates were raised on March 17th 2022.
In Figure 3 we can see how lowering interest rates and easing monetary policy to accommodate for lock-downs, stalled economies and COVID in March 2020 caused all markets to rally due to more availability of capital (M2). However, the inverse is seen in 2022 as the Fed began to hike rates in the face of increasing inflation.
When Will Markets Bottom?
On August 10th – inflation data was below expected and signalled the potential that we had reached ‘peak inflation’, a potential Fed pivot in policy (reducing interest rate rises) and that markets could start to resume their movements upwards following a disastrous start to the year.
The markets and all risk assets subsequently rallied a healthy amount, but have now once again stalled at key resistance levels, thereby maintaining their bearish macro market structures.