Inflation is expected to decline in the upcoming release on Wednesday, with CPI year-on-year projected to drop from 4% to 3.1% according to consensus. The key question is now what lies ahead in terms of the disinflationary trend. The next report on U.S. inflation could mark a significant turning point where the slowdown in disinflationary dynamics might start to taper off in the following months. This uncertainty will keep the FED on hold and leave the market guessing.

Backdrop Considerations

Here some observations outlined below:

# First Observation: Consensus already predicts a significant drop in inflation numbers. The upcoming release on Wednesday anticipates a year-on-year inflation decline from 4% to 3.1%, with core inflation dropping from 5.3% to 5%.

# Second Observation: As the majority of high CPI year-on-year percentage changes are behind us, the lower base effect will come into play, posing challenges for the declining inflation trend. Unless there are financial system disruptions, this will likely keep the FED from taking immediate action.

The chart below, sourced from Bank of America, provides simulated projections of year-on-year inflation levels based on various average monthly CPI changes. The analysis suggests that barring outright deflation, inflation is not expected to return to the Fed’s 2% target, but rather stabilize within the range of 3-4%.

# Third Observation: The 3-4% inflation range is also consistent with the short-term one-year-ahead consumer inflation expectations. Both the FRBNY and the University of Michigan support this projected trajectory for inflation dynamics.

# Fourth Observation: The China Wild Card. In addition to RMB depreciation, China is benefiting from increased competitiveness due to negative producer prices, resulting in a significant correction of export prices. However, despite these tailwinds China’s reopening is currently showing limited momentum, leading to a weak recovery as highlighted by the CPI and PPI numbers in the chart below.

While current dynamics favor disinflation, evolving China policies could impact US and global inflation. If China boosts monetary and fiscal stimulus to revive economic growth, it may counteract the downward trajectory of inflation worldwide.

# Fifth: The Liquidity Trap. I find the next two chart rather interesting.

Chart 1: Post-Pandemic excess savings likely to deplete by September.

Chart 2: Liquidity will really start tightening now as we see a reversal in bank reserves and RRP. Both liquidity indicators pointing down !

Against this liquidity backdrop, positioning in US equity does not look very healthy with Asset Managers chasing the market higher!

Bottom Line

We have a good set-up here to start fading the risky assets rally of the last few months. The upcoming CPI release is likely to fuel optimism regarding inflation and push the remaining bears to capitulate. Therefore, initiating short positions after the CPI release seems favorable. Ideal candidates for shorting could be U.S. growth stocks and cyclical sectors. For those that have a more long-only mandate, it may be the time dust off and review the value-growth rotation playbook.

An interesting alternative could be a rotation into long emerging market assets that may benefit from further Chinese stimulus in the face of faltering growth. And what about rates? Stay put, as I anticipate interest rates to remain range-bound for the next few months. Instead, consider holding 1-3 year U.S. curve sector, potentially leveraged, while remaining cautious about the long end of the curve. How to build up shorts in risky assets? I would build up the short positions over the summer, rather than rushing in. Final capitulation of the bears may be slow during the summer lull. Regarding rates, selling volatility with tail hedged strategies, such as call or put or call flies on U.S. and Germany 2-year rates, could be the winning approach given the recent richness of interest rates volatility.

The chart above, from BofA, shows how the 3M MOVE index (a widely used yield curve weighted index of the normalized implied volatility on Treasury options) jumped to 135 on July 6 from 113 on June 27.

Keeping fingers crossed for the upcoming CPI release, have a great week!

Inflection Point Team

Disclaimer

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