Treasuries Rally as Turkish Currency Woes Outweigh Solid CPI Report

Aug 10, 2018

The July CPI report was just released and mostly met expectations with overall CPI up 0.2% (0.171%) for the month and 2.9% year-over-year. Meanwhile, core CPI rose 0.2% (0.243%) for July and 2.4% for the year. The core YoY rate is the highest in ten years and will certainly keep the Fed on its quarterly hiking schedule. We discuss the inflation report in more detail below but for now the Treasury market is rallying off building emerging market concerns. The Turkish lira took another 10% hit overnight (and 35% since June), and the ECB is voicing concerns over European bank exposure to the collapsing Turkish economy and the threat the currency contagion may spread to other emerging markets. The issue has been lingering in the background for months but traders appear to be forcing the Turkish government’s hand at this point to either hike rates, employ capital controls, seek an IMF bailout, or apply some combination of all-the-above. The relief measures are not what recently reelected President Erdogan wants to hear but absent any action the currency will continue to spiral lower with the risk it spreads to other emerging markets. Thus, the risk-off trade is what will carry us into the weekend despite a solid CPI report. The 10-year note is currently yielding 2.90% up 6/32nds in price and the rest of the curve is in the green as well as flight-to-safety is the trade de jour.


  Economic News


Today’s CPI information for July was the most anticipated economic data of the week, and while it might have some near-term impact on Treasury prices and yields, the results aren’t likely to move the market longer-term nor is it likely to alter the Fed’s hiking scenario by any great degree. Given those two caveats, the report still provides some useful information that leads us to believe the trend in inflation readings may begin to trend lower and that will provide a boost to Treasury prices, and perhaps slow the Fed’s hiking campaign in the longer-term.


What are the elements that lead us to that conclusion? First, year-over-year real average hourly earnings—adjusted for inflation, fell from an unchanged reading in June to –0.2% in July. This is the lowest print since October 2012 and speaks to the impact recent inflation trends are having in eating away at meager nominal wage gains. We’re of the mind consumption will eventually suffer when the consumer is losing purchasing power on an inflation-adjusted basis.  The other issue we find compelling is core-CPI ex-shelter expenses has been running at just 1.5% year-over-year and 1.7% on a three-month annualized basis. That indicates recent core-CPI increases are concentrated in shelter expenses.


We’ve made the point repeatedly in the last year that the market would need to see core price increases spread beyond just the narrow, but heavily-weighted, housing category before putting more stock in a long-lasting and durable inflation increase. Until we see that, the market is likely to keep term (and hence inflation) premiums modest. Also, we would be remiss if we didn’t mention that mortgage applications have been slowing of late as higher borrowing rates temper some purchases at the margin. Could this signal a coming break in shelter-cost increases? More on that in the next section.


As mentioned, one factor keeping longer-term Treasury yields in check has been the narrow term premium and when CPI, both core and overall, rose over 2% many were quick to proclaim that longer-term yields were headed higher. Instead, yields have resisted and the lack of a broadening in inflation pressures is likely one reason that term premiums, and hence nominal yields, have been hesitant to rise.  In fact, the 10-year TIPs implied inflation level--the rate TIPs investor expect inflation to average over a 10-year holding period-– declined from a mid-May high of 2.20% to 2.11% currently.


We think another element to this mostly docile outlook for inflation is the continuing resistance for wage growth to move over 3%, a level that prevailed pre-recession. Released today along with the CPI numbers was the July Real—adjusted for inflation— Average Hourly Earnings figure which was -0.2% YoY. With two-thirds of the economy tied to consumer spending, negative real earnings will limit the ability of consumers to stomach broad-based, durable price increases.


In fact we see some of this hesitance to pass through more wholesale price increases in the difference between PPI gains and CPI. Even with the July PPI numbers, that were generally less than expected, the disparity is glaring with overall PPI of 3.3% YoY versus CPI of 2.9% YoY. Ex-food and energy PPI was 2.7% YoY in July compared to core-CPI of 2.4% YoY. Thus retailers have either been reluctant, or unable, to pass much of the wholesale price increases  onto the consumer. 


That, in turn, will crimp profit margins which could slow profit growth and eventually impact stock prices.  But that’s a story that will take time to develop. The corporate tax cuts have provided a nice buffer this year but if wage gains continue to be modest into 2019, the limited ability to pass through wholesale cost increases will  become more obvious in profit-margin compression. The ongoing tariff war and tit-for-tat retaliation is only likely to exacerbate the cost situation.


The rub of all this is that with inflation momentum failing to broaden into more categories, term premiums are likely to stay muted and that will keep longer-end yields range bound. This is evident especially this week with the largest auctions ever of 10– and 30-year bonds and prices held very close to those existing pre-auction. If investors were anxious over future inflation pressure these auctions would have faced more pricing concessions and the fact they didn’t speaks loudly.




Market Update  Mortgage Applications Slow with Higher Rates


Looking for evidence that higher interest rates are starting to impact consumer behavior? Look no further than mortgage refinancing as one of the first flags. As mortgage rates have steadily risen since early 2017, refinancing is increasingly falling out of favor. The Mortgage Bankers Association index of refi’s fell last week to the lowest level since December 2000.  In addition, purchase applications have cooled as well, pushing the group’s overall mortgage-applications index to its weakest level since early 2016.  As applications lead, or occur concurrently with, purchase contracts, this may portend ill for future home sales activity.


Mortgage Applications Slow with Higher Rates



Agency Indications  Market Rates


Market Rates



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