The stakes for Thursday’s consumer price index inflation report just got a lot smaller. Federal Reserve policymakers are now indicating that the upsurge in the 10-year Treasury yield has reduced already low odds for a rate hike on Nov. 1.
“I will remain cognizant of the tightening in financial conditions through higher bond yields and will keep that in mind as I assess the future path of policy,” Fed Vice Chair Philip Jefferson said in a Monday speech. Jefferson is seen as a centrist on the Fed.
Even more striking, hawkish Dallas Fed President Lorie Logan said “there may be less need to raise the fed funds rate” due to higher long-term interest rates.
10-Year Treasury Yield Reverses
The 10-year Treasury yield surged to a 16-year-high 4.89% shortly after Friday’s employment report showing 336,000 new jobs. But it retreated to 4.78% on Friday and has kept falling. On Tuesday, the 10-year yield slid to 4.65%.
The war between Israel and Hamas that began with weekend terror attacks may be creating a safety bid for risk-free Treasuries. Plus, there are some signs that high interest rates are curbing the strong consumer spending that had led the Fed to turn more hawkish.
Citigroup said last week that customers’ credit card spending at retailers fell nearly 11% in September. Bureau of Economic Analysis data on credit card spending at retailers also indicates a slowdown began in late August.
CPI Inflation Forecasts
The Fed’s primary inflation rate, the core PCE price index, has shown that price pressures have eased dramatically over the three months through August. On a three-month annualized basis, core PCE inflation is running at just 2.1%, down from 3.1% in July. However Fed Chair Jerome Powell has said the Fed needs to see six months of tame data to gain confidence in the trend.
The core CPI hasn’t been quite as tame, rising 0.3% in August vs. a 0.1% gain for the PCE price index. Wall Street economists expect another 0.3% rise in September. That would lower the 12-month core CPI inflation rate to 4.1% from 4.3%. Overall prices, including food and energy, also are seen rising 0.3%, which would trim overall CPI inflation to 3.6% from 3.7%.
Despite August’s bigger-than-expected rise in the core CPI on Sept. 13, the S&P 500 finished slightly higher that day. That may be an indication that the CPI isn’t as important as the PCE in the minds of investors at the moment. One reason is that housing accounts for about 42% of the core CPI but just 17% of the core PCE price index.
The excessive weight of housing makes the CPI less representative of consumer outlays. Plus, the government’s methodology for tracking rents doesn’t fully reflect changes in market prices for about a year. In August, the CPI showed shelter costs up 7.25% from a year ago, while Zillow’s rent index rose just 3.25%.
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Pay Attention To the PPI
Key inputs for the core PCE inflation report at month’s end will come out with Wednesday’s producer price index. The PPI’s measure of health care services inflation feeds directly into PCE data.
Also, the PPI is the source of PCE data on airfares, which is based on the average price per mile traveled paid by passengers. The CPI airfare measure is based on prices for a sample of routes. Recently, the two measures have diverged significantly, with the PPI measure running hotter than the CPI’s, but that might be shifting.
Portfolio management fees, another key input for core PCE inflation, will be previewed by the PPI, and that data should provide good news. These fees surged in July, as the stock market hit its high for the year, then moderated in August. Fees might be flat or down in September, when the S&P 500 had its worst month of the year.
Real Interest Rates Rise
Dallas Fed President Logan highlighted the reason for the higher 10-year Treasury yield as an important consideration. The level of the 10-year yield compensates bondholders for two things: expected inflation and everything else — such as the risk that bond yields will rise over time, which would lower the value of long-term bonds bought today.
If the 10-year Treasury bond yield were rising in tandem with increasing inflation expectations, the Fed would have no reason to pause rate hikes. But the opposite has been true.
Lately, bondholders are demanding a bit less compensation for expected inflation, which means that real interest rates have climbed, contributing to tighter financial conditions.
The inflation-compensation portion of the 10-year Treasury yield is known as the 10-year break-even inflation rate. This is derived by subtracting the 10-year TIPS (or Treasury Inflation-Protected Securities) rate from the 10-year Treasury yield. Since July 25, a day before Chair Jerome Powell revealed that Fed staff no longer expected a recession, the 10-year break-even inflation rate has eased to 2.31% from 2.39%.
Meanwhile, the 10-year TIPS rate, which factors out inflation expectations, has jumped to 2.41% from 1.52%. Since Sept. 19, a day before the Fed’s most recent meeting, the TIPS rate has jumped 41 basis points.
Supply Glut Lifts 10-Year Treasury Yield
Asked on Sept. 20 about the rise in Treasury yields, Powell stated flatly: “It’s not because of inflation.”
Powell highlighted “more supply of Treasuries” and stronger growth as partial explanations. Part of that extra supply comes from Fed quantitative tightening, the unloading of government-backed mortgage securities and Treasuries that the central bank bought early in the pandemic to boost financial market liquidity. The Fed is letting up to $95 billion in bonds run off its balance sheet each month.
Fed Rate-Hike Odds
As of Tuesday afternoon, markets are pricing in just 12% odds of a Fed rate hike on Nov. 1, down from about 27% on Friday. Odds of a rate hike by Dec. 13 have eased to 26% from 42%.
The S&P 500 climbed 0.6% in Tuesday afternoon stock market action. The S&P 500 is looking for a third straight gain and is making a run at its 50-day moving average.
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