Happy Saint Valentine’s Day everyone or, “end of GST/HST holiday eve”. The day typically conjures up images of Cupid firing arrows through the hearts of intendeds. Well, this week, the archer delivered a shaft into the expectations of future interest rate cuts in the U.S.. The January Consumer Price report was hot, with the headline CPI rising 0.4% on the month and core CPI (excluding food and energy) up 0.5%. Both beat even the highest estimates among market economists and validated the remarks by Federal Reserve Chair, J Powell the day before, stating that the Fed was in no rush to continue lowering its target rate. Considering that market participants were already up to their eyeballs with concerns over a looming trade war, a bad CPI print wasn’t desirable. It does present a challenge that potentially goes beyond Donald’s tariff threats.

First, let’s dissect what happened on Wednesday. When the CPI report hit the wires, there was an immediate and predictable reaction. Fed fund futures contracts priced out what notion (wish) remains of a single quarter-point rate cut this year, bond yields spiked, and equity futures dropped. Yes, we have known for a while that core inflation was ‘sticky’ and even the sentiment measures have shown that Americans expect inflation to remain elevated versus where the Fed would like it. Still, the rise in the January headline and core CPI was a stark reminder that the battle to bring inflation down to the Fed’s 2% target wasn’t done yet. Furthermore, if the Trump White House was going to actually deliver on tariff threats and not continue its playground antics of walking back said threats, then there would be an initial bump to consumer prices and hence inflation.

If this confluence of factors was taking place later in the year, the affect on markets may not be as significant, but this is happening at the start. Hence, the base effect of the move higher in consumer prices in January, coupled with price hikes from tariffs will cause inflation measures to be elevated throughout the year, barring an opposing force (like a recession). There will be two key policy figures that won’t like this outcome. One has a solid understanding of how the economy works, while the other doesn’t, yet this new reality is going to potentially cause even more friction between them than there already was.

While CPI ran hot this week and the producer price index (PPI) also came in stronger than expected on a headline basis, key core components of PPI were either muted or lower than the December report. As these factor in the calculation of the Fed’s preferred inflation measure – the personal consumption expenditure (PCE) deflator, markets found some relief on Thursday. That doesn’t mean the story for the Fed has changed. Inflation expectations are still unanchored and could be exacerbated by another price shock. Trump’s tariff plans could provide such a shock.

On Thursday afternoon, Trump’s already weak grasp of basic economics looked even more obtuse as he announced plans to retaliate against all countries that impose retaliatory tariffs against the U.S. Of course, countries are only planning such actions because of the White House’s threat to impose tariffs in the first place. We have already seen steel prices soar in the wake of Trump’s announced 25% hit to Canada and Mexico’s steel and aluminum exports. U.S. manufacturers are going to be significantly impacted should these go through next month, with margins compressed unless they can pass on the higher costs. Which they will because demand is still sufficiently robust. The end users (such as consumers) will ultimately bear the brunt of this cost cascade, adding upward pressure to inflation.

The other side of this coin, however, is whether demand dynamics shift because of even just the threat of tariffs. Your grade 13 or first year economics class dealt with how demand for products would decrease with an increase in price. Therefore, if tariffs and counter-attack tariffs are implemented, then prices will go up on products Americans buy, and they should demand less (unless it’s Canadian maple syrup and you can charge them anything and they will still buy it!).  If consumers anticipate the price hike, they are more apt to front-load their purchases and save money.

Two things can come from this shift in consumption timing. First, it could make for a stronger pace of growth in real personal expenditures in January and February. Since we add an upward seasonal adjustment to sales in those months (similar to why we downwardly adjust in November and December because of holiday-linked sales), the impact on Q1 consumption growth could be magnified. Given that U.S. GDP is 70% consumption, it could give us a pretty robust first quarter print. All things being equal, such a development would only reinforce the Fed’s decision to stand pat on rates.

We don’t know how the Fed is going to respond to this isolated trade action, let alone the almost certain retaliation by Canada and Mexico. It is even harder to figure out the Fed’s reaction to the broad-based White House retaliation announced Thursday. The base case would suggest that the Fed would not raise rates on a temporary move higher in the key inflation metrics, but it would also not be proactive and lower rates any further either. Even though a full-blown trade war would likely send the global economy skidding, and despite Trump ‘logic’, the U.S. would be heavily hit as well, I don’t see the Fed accommodating the higher inflation on a guess of what the impact would be. Until it’s too late of course.

Which brings us back to Trump’s continued banter of wanting lower rates, something his own Treasury Secretary clarified this week but saying he was referring to bond yields and not the official rates managed by the Fed. That said, the prospect of Trump trying to force Chair Powell out of the equation has started to show up in black swan scenarios. Well, if a trade war would be damaging to the U.S. economy and equity markets, it goes without saying that an attempted manipulation of the world’s main central bank would multiply that hit.

That is, for now, a low probability swan but analysts and investors are beginning to wonder about the odds of ridiculousness these days. Even still, anything from the possibility of a protracted pause or tightening by the Fed, to a correction in the bond market on the basis of higher inflation and/or fiscal instability in the U.S. is ultimately going to have to be reflected in equity market valuations. Market participants simply do not know which path we are about to take. 

In my conversations with clients these past two weeks, I have mentioned that the phrase “day by day” never used to be inferred literally as watching for something on a day-by-day basis, but maybe month to month or quarter to quarter. In watching Trump’s policy vacillations, a day is even pretty long. Ally and I maintain that until he actually executes on tariffs (like with China), then we stick to our current investment strategies, while looking for opportunities at the sector and individual company level. If we see actioned policy in the coming weeks that points to a material deterioration in the economy, heightened possibility of higher bond yields and weakened corporate revenue picture, then swift portfolio adjustments will be required. Till then, be prepared for the worst, hope for the best and enjoy a heart-shaped chocolate today.

On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.   

Andrew Pyle