A more tepid CPI report will be needed to change the market consensus, but the US inflation report was modest and quiet, and two-year bond yields, which are highly sensitive to upcoming economic data, did not move much, but the report, however, was contained. A number of interesting pointers about the way forward are that inflation is on the way down.
First, commodity prices fell 0.3% on a monthly basis, and commodity price deflation was a feature of the half-yearly inflation report, driven in particular by a decline in used car prices, although this time, prices for used cars and trucks rose. 1.6% in November, the first monthly increase since May.
Some analysts believe that holiday-related discounts were a major factor behind this.
The next element is accommodation, as CPI rent inflation follows a decline in private market rents as new leases are added to the official data. But the process takes longer than expected.
Rents rose 0.4% in November, slightly higher than the previous month. “We haven’t tested this relationship over multiple cycles,” said BNP Paribas economist Carl Riccadonna. Ultimately, home inflation should come down sharply. Researchers at Pennsylvania State University maintained a live model of inflation and adjusted using real-time market rent data.
After making these adjustments, we see that core inflation has already returned to its target. Finally, non-housing services, known as super core inflation, rose to 0.4% in November from 0.2% in October.
The factor behind this increase was an unusually large increase in medical care prices, which increased by 0.6%. Despite a slight slowdown, auto insurance inflation continued to rise unabated, rising 1% in November. Taken together, these points provide a glimpse into why inflation has been volatile.
The Federal Reserve confirmed that housing inflation will take time to ease, and that it will tackle the decline in goods inflation amid intense volatility around non-residential services. None of this necessarily contradicts the view that inflation is steadily approaching the 2% target, but the lack of clarity gives hawks reason not to rush. Implied volatility in U.S. interest rates, relative to volatility in U.S. stocks, is higher than it has been in nearly 30 years, the data indicate.
From a certain point of view, it is not surprising that the volatility of stocks is very low or “cheap” as we are currently living in an intermediate phase in monetary policy, following very powerful inflation. Events from the early 1980s.
But it is not certain what the benefits will be after that. At the same time, the economy is slowing down, but at high levels and in an orderly manner. On this basis, stocks are in good shape regardless of the direction of interest unless they see a decline following a recession. The difference between the two fluctuations is very strange. And the fluctuations in the cost of money should be reflected in some way in the fluctuations of the stock.
Nitin Saxena, head of US equity derivatives research at Bank of America, offered several explanations for the gap:
• Fundamentals may justify it.
• An inversion of supply and demand for interest and equity options, such as the increasingly popular covered call option strategies, causes overselling of stock options to drive down their prices and subsequently result in stock volatility.
• Technical or “mechanical” factors that control stock fluctuations. An example of this is the decrease in correlation between the components of the S&P 500 this year, meaning that the movements of individual stocks cancel each other out, reducing volatility at the index level.
• Interest rate volatility broadly reflects current economic uncertainty, but equity volatility has become “indifferent” because equity investors “have become accustomed to buying when prices fall over the years and fear upside risk more than downside risk.”
Saxena said: Stocks should stay on the “balancing beam” of a smooth landing and avoid falling due to recession or prolonged high interest rates, which historically lead to volatility in stocks. At the individual stock level, the “absolute move” away from the Big 7 tech stocks and into this year’s profit laggards should be huge, as alternatives to these stocks:
• You will become better and trade at higher P/Es.
• The Big 7 tech stock bubble will burst, both of which will lead to high stock volatility.
Amy Wu Silverman, equity derivatives strategist at RBC Capital Markets, emphasized the timing issue, saying that from a multi-asset perspective, it’s tempting to say “equity volatility is cheap” compared to interest rate volatility, but the reality is the potential for survival. The ever-present problem in this structured, (derivatives trading) world over a long period of time is that we never know when “the music stops playing”.
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