The Big Picture

Briefing.com Summary:

*Inflation remains elevated, with CPI and PPI accelerating further above the Fed’s 2% target.

*Rising Treasury yields have effectively tightened financial conditions, reducing pressure for immediate Fed action.

*Markets expect the Fed to stay on hold, as inflation fears ease and bond markets have done the tightening.

The past week produced the Consumer Price Index for May and the Producer Price Index for May. Both reports made it clear that inflation remains a problem. The Consumer Price Index was up 4.2% year-over-year versus 3.8% in April. The Producer Price Index was up 6.5% year-over-year versus 5.7% in April.

There was much ado about the fact the core readings for these reports, which exclude food and energy, were tamer, suggesting there hasn't been as much pass-through to core inflation from rising energy costs as had been feared. Core CPI was up 2.9% year-over-year versus 2.8% in April, and core PPI was up 4.9% year-over-year, unchanged from April.

The inflation rates continue to linger uncomfortably above the 2.0% level the Federal Reserve has identified as its target inflation rate, albeit for PCE inflation, yet these reports are swimming in the same pool of public perception.

For all intents and purposes, the market swam a few victory laps after these reports, aided by the hope that oil and gasoline prices are poised to disinflate with news of a peace deal between the U.S. and Iran.

They also benefited from a belief that the Fed may not have to raise rates for some time. Stop and think about that for a moment.

A year that started with an expectation that the Fed would cut rates two or three times before the end of the year is bubbling with excitement that the Fed may not have to raise rates before the end of the year.

Hold Your Fire

Several Fed officials are not happy with the state of inflation and have averred that it may be necessary to raise interest rates to get inflation under control. That will be a thoughtful point of debate at the coming FOMC meeting, the first to be managed by new Fed Chair Kevin Warsh, but it may just be a moot point considering the Treasury market has already done its own tightening work.

When the year started, the 2-yr note yield stood at 3.48%, and the 10-yr note yield rested at 4.17%. By the time the war with Iran started in late February, the 2-yr note yield was at 3.40%, and the 10-yr note yield was just under 4.00%. Today, their yields sit at 4.08% and 4.48%, respectively, but they had gotten as high as 4.16% and 4.66%.

Those higher yields hold some added appeal for fixed-income investors, but they also make it more expensive to finance a new home or to refinance debt issued at lower rates. That is, they can be demand killers and/or repayment burdens that slow growth.

In turn, higher rates weigh on equity multiples and can drive down stock prices, which curb the wealth effect and, tangentially, consumer spending.

When the Fed raises the target range for the fed funds rate, its aim is to slow growth to keep inflation in check. It hasn't been quick to raise rates in the face of rising energy prices, though, because the Fed realizes it can't control energy costs, which are volatile. Moreover, it is cognizant that price spikes associated with geopolitical events are often temporary.

That is why a move in WTI crude futures from $65.00/bbl at the start of the war to $112.00/bbl when the tenuous ceasefire was announced in early April didn't prompt a hasty rate-hike decision. Instead, it drove a prevailing wait-and-see mindset that persists today. That disposition is nearly certain to remain in place following the June 17 FOMC meeting, especially since oil prices have backed down to $85.00/bbl, and there is talk that a memorandum of understanding for peace between the U.S. and Iran could be imminent.

Briefing.com Analyst Insight

Interestingly, the yield on the 10-yr note is about 20 basis points higher today than it was when oil prices peaked in early April. The market, therefore, hasn't been wholly dismissive of the potential pass-through effects of higher energy prices, partly because it is also aware that AI buildout efforts are creating pricing bottlenecks elsewhere. And it's not as if there isn't inflation beyond food and energy prices. There is, and it hurts many consumers to the core.

That point notwithstanding, the market is less fearful that the current inflation is going to turn into runaway inflation. That is evident in the 5-year breakeven inflation rate, which, at 2.40% today, is exactly where it was the day the war with Iran started.

That is notable, but so, too, is the recognition that this measure of what market participants expect inflation to be in the next five years, on average, is still above the 2.0% target rate.

The Fed isn't going to be cutting rates soon, and it also has some cover, with oil prices and breakeven rates coming down, not to raise rates soon either. The Fed doesn't need to, not when the market has done its bidding for it.

This leaves Fed Chair Warsh in a good spot entering his first meeting as Fed chair. He won't have to sell a hard case for cutting rates now, and he won't have to spoil his debut with a rate hike. The market has taken care of all this for him, exercising its own rate hike in our midst.

--Patrick J. O'Hare, Briefing.com