The Rhyme: Factory Input Costs Are Screaming & Its 2011 Echo

"History doesn't repeat… but it rhymes." — Mark Twain

The ISM Manufacturing Prices Paid index surged 6.8 points to 77.9 in September, the sharpest monthly jump since February and the highest reading since May. The number dropped on Wednesday and the bond market noticed immediately: ten-year yields ticked up to 5.28 percent, their highest close of the year, even as Friday's payrolls came in soft at 29,000. Oil is the engine driving it all, with Brent holding above $102 after China suspended refined fuel exports for October and the Strait of Hormuz remains under threat. Today's ISM Services report, due at 10 a.m., will show whether that price surge has bled from the factory floor into the rest of the economy.

ISM Mfg Prices Paid: 77.9 (+6.8 pts)  |  ISM Mfg PMI: 54.5  |  Brent: $102  |  10Y: 5.28%  |  S&P 500: 7,723  |  Fed Funds: 3.75–4.00%

The last time factory input prices screamed this loud while the headline PMI still looked healthy was fifteen years ago. That story ended badly.

On the evening of February 15, 2011, about five hundred people gathered outside the police headquarters in Benghazi, Libya's second-largest city. They were angry about the arrest of a human rights lawyer. Security forces fired rubber bullets into the crowd. Two days later, on what organizers called the Day of Rage, thousands poured into the streets and Muammar Gaddafi's forty-one-year grip on the country began to crack. Within a week, foreign oil workers were scrambling onto charter flights out of Tripoli, the eastern half of the country was in rebel hands, and nearly 1.5 million barrels a day of the world's sweetest, lightest crude was gone from the market.

The oil market moved before the headlines caught up. Brent jumped from $102 to $119 in four trading sessions. By late March it was above $115. By mid-April it had touched $127 — the highest since July 2008 — and nobody in the market believed it was coming back down anytime soon. Analysts pointed out that Libya's crude was the kind European refiners loved, light and low-sulfur, and there wasn't an easy substitute. Saudi Arabia pumped more, but it was heavier, sourer crude that didn't fit the same refineries. The mismatch between what was lost and what replaced it pushed diesel and jet fuel cracks to levels not seen since the financial crisis.

On April 1, 2011, the ISM released its Manufacturing Report for March. The headline number was 61.2 — deep in expansion territory. Factories were running hot. Order books were full. Employment was expanding strongly, just off February's fastest pace since 1973. But buried on page two was the number that mattered more than any of those: Prices Paid had surged to 85.0, up from 82 in February, and 81.5 in January. More than eighty-five percent of purchasing managers were reporting higher input costs. Steel, aluminum, diesel, petroleum-based chemicals — everything was getting more expensive, and the cost increases were accelerating month over month. The ISM chair that morning called it "a red flag that bears watching."

Wall Street barely shrugged. The S&P 500 was sitting at 1,325 and climbing. GDP was positive. Earnings were beating estimates. The Federal Reserve's second round of quantitative easing was still pumping $75 billion a month into Treasuries. The Fed's official position was that the oil-driven inflation was "transitory" — a word that would later become infamous in a different context. Chairman Bernanke told a press conference in late April that he expected commodity prices to stabilize and that underlying inflation remained well-contained. The S&P 500 peaked at 1,363.61 on April 29th. Almost nobody saw what was coming next.

Both times the headline PMI said "expansion" while the Prices Paid subindex was screaming that the oil shock had already crawled inside the cost structure of every factory in America. Both times the market looked at the strong top-line number and ignored the one underneath it.

Here is what happened next in 2011, told in the order it happened. On May 2nd, the ISM released the April manufacturing data: the headline PMI had slipped from 61.2 to 60.4, a modest pullback, and Prices Paid had surged again to 85.5, the highest reading since July 2008. The market glanced at it, yawned, and bought the dip. Three days later, on May 5th, WTI crude crashed 8.6 percent in a single session — dropping $9.44 to fall below $100 — after a string of weak economic data hit the tape all at once. It was the biggest one-day oil collapse since April 2009.

Then came June 1st. The May ISM report dropped like a stone: 53.5, a nearly seven-point decline from April, the kind of single-month collapse that makes traders rethink everything they thought they knew about the economy. GDP for the first quarter was initially estimated at 1.8 percent annualized, and the second quarter would come in at just 1.0 percent. The economy was stalling. On June 23rd, the International Energy Agency took the extraordinary step of coordinating a release of 60 million barrels of strategic oil reserves from 28 member countries — only the third such action in the agency's history. It was an admission that the market couldn't fix itself.

The S&P 500 had peaked at 1,363.61 on April 29th. By early August, the US debt ceiling crisis and Standard & Poor's downgrade of US debt compounded the damage. On October 3, 2011 — fifteen years ago to the day and almost exactly the same calendar date as right now — the S&P bottomed at 1,099.23. That was a 19.4 percent decline from peak to trough. The smart money had moved into Treasuries by late May, when the ten-year yield began its long slide from 3.17 percent to 1.72 percent over the following year. The trade wasn't complicated: you watched the Prices Paid index peak, you waited for the headline PMI to confirm the crack, and you repositioned before the crowd realized the strong top-line number had been masking a cost structure that was quietly strangling margins everywhere.

Today the Prices Paid index is screaming the same warning. The ISM Services report at 10 a.m. this morning will tell you whether the signal has spread from factories to the rest of the economy. In 2011, it took about thirty days from the Prices Paid peak to the ISM headline collapse. If that cadence holds, the window is somewhere between now and the first week of November.

In 2011, the Prices Paid peak in April preceded the PMI collapse in May by exactly one month. The ten-year yield began falling two weeks after the PMI broke. Those who watched input prices instead of headline growth had a sixty-day head start on the rest of the market. Today's Prices Paid reading of 77.9 is that same signal, flashing from the same place, for the same reason. The question isn't whether input costs are rising. It's whether the headline PMI can absorb them — and in 2011, the answer was no.

Wednesday's FOMC minutes from the September meeting will reveal how many governors flagged the ISM Prices Paid surge as a reason to keep hiking. If the internal debate mirrors early 2011 — when Bernanke dismissed commodity inflation as transitory while several regional Fed presidents dissented — the market may start pricing a November hike that nobody currently expects. In 2011, that internal fracture became public by midsummer, and the policy confusion helped accelerate the selloff.