The first in a series of inflation readings this week is out this morning with September Producer Prices coming in mostly as expected. The month-over-month gain was 0.2% for both the overall and core with the overall YoY increasing 2.6% versus 2.7% expected and core YoY matching the 2.5% forecast. Treasuries were trading in the red prior to the PPI release as stronger data out of the UK, EU and Japan adds to pressure provided by upcoming supply this afternoon. The more relevant inflation reading will come tomorrow with September CPI providing a better tell on retail level inflation trends. Expectations are for overall CPI to dip 3/10ths to 2.4% and Core CPI to tick up to 2.3% versus 2.2% in August. If those expectations are met it will show inflationary forces are generally stable. As mentioned, Treasuries are under some pressure this morning as better overseas data combines with an upcoming 10-Year Treasury auction that has the 10-year note off 8/32nds to yield 3.24%. Once we’re through the inflation readings this week, and supply, it may provide an attractive entry point if we hold the recent high of 3.26%.
|Economic News||TIPs 5-Yr Breakeven Inflation Expectations||Agency Indications|
As we mentioned in yesterday’s Market Update this week is all about inflation as several reports will provide further illumination on the subject of whether inflationary forces are building or remaining tepid. The aforementioned PPI, CPI, Real Average Hourly Earnings and Import Prices will get an airing this week and if expectations come to pass it will show that inflationary forces are generally stable. The most important of the releases is the September CPI Report which is due tomorrow.
Expectations are for CPI to be up 0.2% matching the gain in August. The core rate (ex-food and energy) is also expected to increase 0.2% versus 0.1% in August. On a year-over-year basis, CPI is forecast to drop 3/10ths to 2.4% from August’s 2.7% while core CPI YoY is expected to increase 1/10th to 2.3% versus 2.2% the prior month. While the YoY measures are above the Fed’s stated 2% benchmark the Fed’s preferred inflation measure, core PCE, remains slightly under 2% at 1.96%. That being said, the trend in PCE is towards 2%, and with decent wage gains continuing the Fed seems secure in the belief that inflation is moving toward its 2% benchmark. If the expected readings come to pass they won’t, however, indicate another leg higher in inflation and so it’ll be interesting to see how Treasury yields react given the back-up in the last couple weeks.
One of the reasons cited for part of the recent back-up in Treasury yields is that investors are acknowledging a greater level of economic growth and inflation leaking into the economy. One way to check that theory is to look at pricing in the Treasury Inflation-Protected securities (TIPs) market. TIPs receive compensation based on the Core CPI index and that historically runs about 30bps above Core PCE. Current pricing in the 5-year TIPs market has breakeven inflation expectations at 2.06% versus the current Core CPI rate of 2.2%. Thus, the TIPs investors see inflation remaining under control, and actually trending under the current Core CPI rate. Meanwhile, the Fed projects Core PCE will average 2.1% over the next several years which implies something around 2.4% for Core CPI.
It would seem if the market were truly pricing in a greater inflation premium it would be reflected in higher inflation expectations as expressed by TIPs breakeven rates. And while the 5-year breakeven level has risen from 1.95% in mid-August it’s still well shy of the yearly high of 2.17% set back in May. It seems much of the increase in real yields is more technically-inspired than something more fundamentally-driven and with TIPs pricing fairly benign inflation expectations that’s a strong tell on that.
If inflation readings this week exceed expectations and signal gathering inflation bleeding into the economy then you can expect those TIPs breakeven levels to reprice higher and provide another bearish impulse to Treasury yields. If, however, the inflation readings come close to expectations, or below, it will provide another signal, in addition to the TIPs market, that inflation is still fairly benign and not a reason to sell Treasuries.
Another reason we see the selling in Treasuries as more technically-inspired and not fundamentally-based is the lack of increasing real wage growth. The employment report from last Friday signaled good-but-not-great wage gains of 2.8% YoY. That level remains below the pre-crisis 3.0% to 3.5% rate and thus failed to show consumer wallets are bulging with more spending power. In fact, tomorrow, in addition to CPI, we get Real Average Hourly Wage growth for September which is expected to show a modest gain of 0.2%YoY. That’s barely above breakeven after accounting for inflation and certainly not a sign that consumers are feeling flush with extra cash.
And that wage expectation begs the question that with an economy operating at a 3.7% unemployment rate and new jobs averaging 200k per month what would it take to get wage gains moving above the 3.0% YoY rate? Perhaps with a Labor Force Participation Rate seemingly capped at 62.7%, and well short of the pre-crisis average of 66%, there is still some shadow slack that is keeping wage gains in check? Whatever the underlying reason, until we do get better wage gains it seems expecting a durable increase in inflation will remain elusive.
TIPs 5-Yr Breakeven Inflation Expectations
One reason given for some of the recent back-up in yields has been investors revisiting their growth and inflation expectations given the recent run of solid economic releases. The TIPs market provides one a real-time check on inflation expectations as part of the payment on a TIPs bond is the Core CPI index rate. Thus, as TIPs prices change it implies a change in inflation expectations. The graph illustrates the inflation expectation for a 5-yr TIPs bond. While the rate has moved higher since mid-August, when it was 1.95%, the current rate of 2.06% is still below the yearly high of 2.17%. Thus, while there are likely several reasons to explain the recent back-up in yields, increasing inflation expectations explains only about 10bps of the move.
Agency Indications — FNMA / FHLMC Callable Rates