Leveling the Playing Field

November 23, 2015

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I lost a wager on the Eagles vs Panthers game a few weeks ago to a client based in Charlotte. I had to
show up at their office adorned, head to toe, in Panthers gear. Literally, head to toe. I had concluded
that Mondays newsletter with Real men dont wear teal! and my appearance only confirmed that
sentiment.

But during that meeting, I was asked what my number one concern for 2016 was? What did I think
could be lurking that would derail the expansion? What could cause the 10T to jump to 3.00%? What
could send short term rates running higher faster than expected? China? Greece? Terrorism? Chip
Kelly not losing his job?

Inflation.

Perhaps ironically, it was this very same client that had first raised my awareness to inflation when he
complained about construction costs about 18 months ago. It is a common issue today, but at the time
it was the first I had heard of costs rising rapidly. It was the first time I had thought about inflation in
over 5 years.

We noted in the newsletter on November 9th that we didnt see the 10T running up to 2.75% in the near
term unless:

1. The FOMC is viewed as being behind the curve
2. Inflation picks up sharply

Its important to note that we wouldnt consider this to be our base case but it is one that we worry
about. Six plus years of ZIRP and a transparent Fed have perhaps set a complacency trap. The Fed has
beat a dead horse with its message about the upcoming tightening cycle being gradual and most
discussions around mistaken Fed forecasting focus on the downside. In other words, if they are wrong it
is likely that they will be forced to hold off on rate hikes or even cut rates in 2016. Were in that camp,
too.

But what if inflation picks up?

Markets will move well-ahead of any Fed response to increased inflation. That means rates across the
curve run up, with the biggest impact most likely felt on the front end of the curve. The 2T is sitting at
0.91% right now, up sharply in the last month because of the increased likelihood of a Fed hike. Throw
some inflation gasoline on the fire, and is it inconceivable that it runs to 1.50% in short order? Or that
traders abandon ship on the 10T and it runs up to 2.75%? Or 3.00%?

And if the Fed doesnt respond, it could be viewed as falling behind the curve and exacerbating the
problem, which will result in even more selling.

Core CPI has been ticking up ever so slightly this year, from 1.6% to 1.9%, but other than that most of
the following graphs dont highlight much concern for inflation on the horizon. I feel a bit like Tom
Cruise in A Few Good Men when he submits into evidence the towers flight log books that show a flight
that never took off or landed at the airport despite the fact that he was claiming it had.

Judge: I don't understand; you're submitting evidence of inflation that never existed?
JP: We believe it did Your Honor. Exhibit A is Core PCE and Core CPI.

Core PCE (Feds preferred measure) five year history

Core CPI (five years)

Neither of those graphs look intimidating, right? But I cant help but wonder if this time next year we
will be looking back at todays levels and referring to them as the trough before the rebound.

Central bank policy is driven in part by inflation expectations because inflation is one of those tricky selffulfilling prophecy data points. If you believe something will cost more in a year, you are more likely to
buy it now. And you may even pay up a little vs the cost today because it still represents a savings vs
your own expectations for next years cost. So the Fed has to respond to a rise in inflation expectations.
Enter Exhibit C inflation expectations.

Inflation Expectations - One Year Forward

Inflation Expectations - One to Five Years Forward


Again, those graphs seem to be proving the exact opposite the concern I raised. I get it. But inflation
expectations are driven by headline inflation numbers, not the core inflation the Fed prefers.

As a reminder, the core reports the Fed prefers exclude food and energy components because they
are subject to the whims of trading volatility. Commodity contracts can go haywire without the
underlying item actually experiencing a dramatic price fluctuation. The Fed prefers to measure the
underlying item itself, not the trading market hence the use of core data.

But consumers absolutely care if the food and commodity prices the core reports exclude increase,
right? Heres a five year graph of the headline CPI data, lets call it Exhibit D.

CPI Headline

Couldnt that look an awful lot like a bottoming out a year from now?

And if headline inflation numbers start to pick up, that should flow through to the inflation expectations
graphs above.

And the Fed will have to respond to that.

Thats what worries me.

Perhaps the biggest argument against inflation this year has been stagnant wage growth. Prices have a
tough time going up if people arent getting paid more. Check out the average hourly earnings graph
showing the last five years, Exhibit E.

Average Hourly Earnings

If unemployment continues to fall, shouldnt this graph continue to see upward pressure? And if wage
growth finally starts showing up, couldnt that lead to higher inflationary pressure?


Closing Argument
I dont have some corny You cant handle the truthabout inflation line to wrap this up, but perhaps
2016 will see focus shift from the job data (NFP and UR) to inflationary data (PCE and CPI)?

The difference between an unemployment rate of 4.6% and 4.7% seems insignificant, but the difference
between CPI of 1.9% and 2.0% could be more meaningful in the collective mind of the market.

Again, this is not our base case. We are speculating on the current levels representing a trough. And
there is plenty of global deflationary pressures to help keep a lid on prices domestically. And the
upcoming tightening cycle could throw us into a recession. And and and and and

But, if (and that is a BIG IF) inflation starts showing up in the data, the market wont wait for the Fed.
Rates could jump significantly in very short order. And that would make for a very volatile 2016 despite
the Feds assurances of a gradual liftoff.

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