Has Inflation Finally Arrived?

Markets closed today for the holiday, and between a volleyball tournament in Atlanta and a conference in Orlando, you are getting the cliff notes version this week.  I know, you are crestfallen.

Last Week This Morning

• The 10 year Treasury began the week at 2.88% and ended at 2.87%, but that doesn’t accurately convey the volatility. It peaked at 2.93%, a four year high, and troughed at 2.82%.
• The 2 year Treasury started the week at 2.07% and climbed to 2.20% over the course of the week.
• Core CPI came in at 0.3% vs 0.2% MoM and 1.8% vs 1.7% YoY.
• Core PPI came at 2.2% YoY, above the 2.0% expectation as well. MoM also beat expectations, coming in at 0.4% vs 0.2% expected.

Has Inflation Finally Arrived?

Last week, Core CPI stunned to the upside, with a higher than expected 0.3% print – the strongest since 2005.  Headline CPI also came in higher than expected, with a 0.5% increase.

If my kids grades were linked to CPI, they would have been arguing with the BLS…you see, these numbers were ever so close to being reported as even higher.

Core CPI actually came in at 0.349%…just 0.001% more and it would have been reported as 0.4%.  MoM Core CPI has only hit 0.4% a handful of times in the last twenty years.  This was a staggering number.

Headline CPI came in at 0.5448%…just 0.0012% more and it would have reported as 0.6%.

Inflation (or lack thereof) has been shockingly reluctant to play along with the rest of the recovery.  If, and this is a big if, inflation is finally starting to show up, yields could experience significant upward pressure.  Global PPI came in above 3%, and higher commodity prices haven’t really factored in yet.

Core PCE, the Fed’s preferred measure of inflation, is due at month end.  If it jumps like CPI and PPI, the 10 year Treasury could easily break 3.0%.

Perhaps 2018 will be the year inflation, like the Eagles, finally shows up (you’re welcome Eagle haters).

FOMC Minutes

The January FOMC meeting, Yellen’s last, was slightly more hawkish than expected.  This week we get the minutes from that meeting to see if our interpretation was correct.

The Fed has been clinging to the “inflation softness is transitory” narrative for a year now, and the minutes may reveal just how strongly Fed members feel that softness is coming to an end.  Much of the language from the formal statement revolved around an upbeat outlook:

• economy is “solid”
• inflation is expected to “move up this year” and market based measures of inflation compensation “have increased in recent months”
• Fed expects “further increases in the federal funds rate”
• Business investment outlook upgraded

One key question the market hopes the minutes will shed light on is the probability for a deviation from the current projected path of Fed Funds.  The Fed is projecting three hikes this year – was there any talk of adjusting this higher to four hikes?  Alternatively, was there any discussion about letting the economy run hot to make up for such a prolonged period of depressed inflation.

In the December minutes, “a few” members felt three hikes was too high while “a few” thought more than three would be appropriate.  How did these discussions go in January and has either side begun shifting sentiment?  For example, if a “few” wanting more than three hikes changes to “several”, the market will likely push rates higher (particularly on the front end = bad for caps).

Lastly, does the projected path increase above 3% in the long run?

Gut feeling – it’s too early for the Fed to start sending these signals, particularly only a few weeks after the equity flash crash.  But it is something to monitor over the next several months if the data supports it.

Fixed Rates

Net short contracts on the 10 year Treasury peaked in February 2017 after Trump’s inauguration.  After that, the yield largely traded sideways and gradually grinded lower.  While the absolute volume of contracts today is less, the duration weighted shorts is approaching similar duration weighted shorts experienced then.

This gives some hope that the recent spike in yields will slow…then again, one of the primary culprits of the slow grind lower in rates last year was five consecutive inflation misses.  Based on last week’s CPI data, that seems unlikely to repeat itself this year.

Keep an eye on month end Core PCE.  That is the Fed’s preferred measure of inflation and hasn’t hit 2% in six years.  If that surprises the way CPI surprised last week, rates could be off to the races.

This Week

Markets are closed Monday and not much data to speak of, with the aforementioned FOMC minutes being the most significant release.  Quite a few Fed speakers, which could move markets.