The Green Lantern

Before you get upset and proclaim – this isn’t going to be some geeky superhero-filled commentary given the title – relax – we will not color this discussion with thoughts of Superman or Wonder Woman or the strangest superhero of them all – The Green Lantern, whose only super power seemed to be that he could wear a ring that gave him weird powers and – there we go, talking about superheroes, which we promised not to do.

Rather, the “Green Lantern” we are referring to is the latest inflation data, which is giving some hope – green shoots if you will – that the efforts of the Federal Reserve and the Bank of Canada (not to mention the ECB, the BOJ, and the NYPD) have finally begun to tame the proverbial beast. Let’s look at a chart and then comment:

Month-over-month CPI came in at 0.1% in March (actually 0.054% to the third decimal), which lowered annual CPI to 5.1%, the lowest it has been since the spring of 2021. While 5.1% is still way too high, it is worth noting that we are at nearly half the levels of annual CPI we were at 12-months ago and for the first time since the rate hiking cycle began in early 2022, annual CPI has fallen to near the level of interest rates:

And as we have pointed out before, we are going to be running into the teeth of some very chubby monthly CPI readings over the next few months, which should act to further bring down annual CPI:

While monthly CPI a year ago was 0.3% for April, it surged to 1% and 1.3% in the ensuing two-months. If we were to see these three readings replaced by the monthly average over the past 6-months – ~0.2% - annual CPI would drop to roughly 3% by early summer. Further, and again, something we have talked about before, we are beginning to see some movement in Owners’ Equivalent Rent (OER), which is a weird construct designed to capture some component of housing costs in CPI, and has been feeding a fair bit of the inflation narrative over the past 6-months:

While one might need a green lantern to see a discernible drop in OER, it has at least begun to plateau, which is in keeping with the narrative that changes in OER tend to lag changes in housing prices by 6-9 months. Housing prices have continued to head lower, which bodes well for OER potentially turning negative in the near-term:

If we were to strip out OER from the inflation data or at least imagine a world in which it was beginning to contribute to CPI coming down (as we suspect it will in the coming months), annual CPI would already be approaching levels that would likely make central bankers much more comfortable:

So, what does this mean to interest rates? The Bank of Canada once again chose to stand pat on the current level of interest rates – 4.5% - and all indications are that this will be the peak in rates for the current cycle. Conversely, the U.S Federal Reserve still seems likely to raise rates at least one more time, which would bring the overnight rate to above 5% for the first time in nearly two decades. But with inflation coming downs and continued risks around the U.S. regional banking sector, the market has largely priced out any further rate hikes. Market participants still price in some probability of rate cuts by the end of 2023; although, we remain skeptical to this, as the “stickiness” of inflation over the past 2-years is likely to make central bankers reluctant to lower rates too quickly driven by fears that inflation reinvigorates.

So, what does this mean to markets? If the last 16-months have been a tunnel, we are at least approaching the end of it (with a green lantern in hand). We still suspect that there is some messiness to come in the next 6-9 months as the ripple effects from 400+ basis points of tightening in both Canada and the U.S. have yet to fully play out. We have described the long-term opportunities that markets such as this can present, so rather than approaching the second half of the year with trepidation, we are interested to see the opportunities that arise.