Will CPI surprise to the upside? … higher energy prices and a bad comparable month are a dangerous combo … higher home prices and inflation … the U.S. gets a credit downgrade

 

Next Thursday, we get the latest Consumer Price Index (CPI) report – and it could be a little toasty.

After months of falling inflation, two dynamics are intersecting than could result in a hotter-than-expected CPI print: the highest oil prices in months, and a terrible comparable month.

Beginning with oil, as you can see below, since June 13th, the price of West Texas Intermediate Crude (the U.S. benchmark for oil) and Brent Crude (the European benchmark) are up, respectively, 21% and 19%.

Here’s Barron’s with the impact on gasoline prices:

Prices at the gasoline pump hit an eight-month high and extended their monthlong gains, with signs that prices could keep rising during peak summer driving season.

The average U.S. retail gasoline price rose to $3.7137 a gallon [last Thursday], the highest since Nov. 17, 2022, according to Oil Price Information Service.

In California where I live, we’re back above $5 a gallon. Yesterday, I saw a photo of one gas station charging more than $7 a gallon.

No one likes higher gas prices but energy’s weighting in the CPI clocks in at only 7%. So, this surge in oil/gasoline prices likely would not make a tremendous difference in the overall CPI figure.

But when you combine it with the second dynamic – the bad comparable month – that’s when the risk of a hotter CPI number picks up.

A “first-to-worst” change in “comparable” months for the July CPI reading

Remember, reports like the CPI measure changes in price. So, we need a beginning value and an ending value.

If we want inflation to look small, then the higher the beginning value, the better. Alternatively, the lower the beginning value, the greater the risk of a “hot” reading.

Well, last summer, the CPI went from “highest starting monthly value” to “lowest starting monthly value” in consecutive months.

Here’s how this looks:

Heading into next Thursday’s July CPI reading, our beginning value has dropped off a cliff compared to the June beginning value.

Translation – even modestly higher prices in energy could have a meaningful impact on the overall CPI number since our starting comparable is so low.

But will this upward pressure on the CPI be offset by the time-delay in home prices?

Energy’s 7% weighting in the CPI pales compared to the approximate 33% weighting of housing (called “shelter” in CPI parlance).

But as we’ve pointed out here in the Digest, changes to housing costs don’t make their way into the CPI immediately.

From CNBC:

The CPI doesn’t capture [housing] price trends in real time.

It operates with a substantial lag, meaning it can take six months to a year for a decline (or increase) in current housing prices to fully feed through to inflation data, economists said.

Today, we still have the tailwind of lower shelter prices from six-to-12 months ago.

To illustrate, here’s the Case-Shiller U.S. National Home Price Index. I’ve added a demarcation beginning last July.

You can see we’re on the downslope of a favorable stretch carrying us through the end of the year.

But the CNBC article highlighted “six months to a year” of lag time, and that difference could have an enormous impact on inflation readings this fall

The devil is in the details.

If the housing time delay is actually six months rather than 12, any help that cool housing data provides for next Thursday’s CPI print could reverse in August. In that case, our comparable month would be February 2023 which as you can see above, shows the first uptick in home prices.

But even if it takes longer for higher home prices to work their way into the CPI data, it’s clear where things are headed.

Here’s Redfin with what home prices are doing today on a year-over-year comparable basis (which is a preview of CPI prints to come):

The median home sale price was $381,750, up 2.6% from a year earlier. That’s the biggest increase since November.

Touring activity as of July 23 was up 11% from the start of the year, compared with a 4% decrease at the same time last year, according to home tour technology company ShowingTime. 

Bottom line: Next week’s CPI reading will be interesting to watch and could be hotter due to energy/comparables. But the far greater risk of hot CPI prints remains out on the horizon thanks to home prices.

Of course, a hotter CPI means Federal Reserve Chairman Jerome Powell might have more work to do later this year even though Wall Street broadly believes we’ve reached peak rates.

Meanwhile, how will gridlock in the housing market resolve?

As we’ve covered here in the Digest, homeowners aren’t selling in today’s climate. But it’s not just because they’re sitting at home, counting their monthly mortgage savings (relative to today’s mortgage rates) and their ballooning net worth (thanks to the runup in housing prices).

Rather, they can’t afford to become buyers themselves.

Yesterday, CNBC reported how many Americans “feel trapped in their homes.” It’s the flip side of the same coin plaguing would-be homebuyers – affordability.

While many existing homebuyers want to sell today, they can’t. With home prices up nearly 40% since 2020, and mortgages now at 7%, many existing homeowners are just as priced-out of today’s market as the would-be homebuyers.

From CNBC:

The recent spike in mortgage rates has created a so-called golden handcuff effect.

The term is often used to describe financial incentives employers may offer to discourage employees from leaving a company. For homeowners, a low mortgage rate is similar. 

Most homeowners today have mortgages with interest rates below 4% or even below 3%, after moving or refinancing when rates hit record lows during the Covid pandemic.

Nearly 82% of home shoppers said they felt “locked-in” by their existing low-rate mortgage, according to a recent survey by Realtor.com.

Because of that, there is a critical shortage of homes for sale, with year-to-date new listings roughly 20% behind last year’s pace.

So, where’s the mortgage-rate sweet spot that would help relieve this gridlock?

Zillow suggests it’s about 5%. But with the Fed appearing unlikely to lower rates at all in 2023, a 5% mortgage rate doesn’t appear likely anytime soon.

Home sales are likely to be limited to two groups: deep-pocketed buyers who can afford home prices hovering around all-time highs, with mortgage rates at 7%…and highly motivated sellers who must list their house for some reason (think a retiree moving into a health care facility).

Since there aren’t tons of buyers and sellers that fall into these two categories, expect record-low housing inventory on the market to continue…which just puts more upward pressure on prices.

It’s a self-reinforcing upward price spiral until an outside force (say, the Fed?) changes direction.

But coming full circle, what do we know about the upcoming direction of home prices that will make their way into the CPI reports this fall and winter?

They’re headed higher.

And with shelter costs accounting for 33% of the CPI, that’s likely to be some serious upward pressure on inflation.

So, what’s the Fed’s likely response?

Well, either hold rates steady or increase them…which decreases the odds that those golden mortgage rate handcuffs will be loosening anytime soon.

Before we wrap up, there are two interesting/conflicting headlines that capture where we are today

Yesterday brought news of the first big bank reversing its call for a recession.

Here’s Bloomberg:

Economists at Bank of America Corp. scrapped their forecast for a recession in the US, becoming the first large Wall Street bank to officially reverse its call amid growing optimism about the economic outlook…

“Recent incoming data has made us reassess our prior view that a mild recession in 2024 is the most likely outcome for the US economy,” BofA economists, led by Michael Gapen, wrote in a note to clients on Wednesday.

At the same time, Fitch Ratings just downgraded the U.S. government.

From a different Bloomberg article:

Fitch cut the US’s sovereign credit grade one level from AAA to AA+. The move comes just two months after it warned the rating was under threat as lawmakers flirted with default by battling over raising the nation’s debt limit.

The credit grader justified the shift by arguing the country’s finances will likely deteriorate over the next three years given tax cuts, new spending initiatives, economic shocks and repeated political gridlock.

My fellow-Digest-writer Luis Hernandez summed up the conflicting news nicely:

Kind of what we all know…

Short-term we are doing well, but the long-term risks are there and it’s tough to deny them.

That’s why our approach to the market today remains what it’s been for months now – maintain a nimble, trader’s mindset to enjoy bullish conditions for as long as they’re here, but be alert to storm clouds that remain out on the horizon.

Have a good evening,

Jeff Remsburg