We got some important inflation data this week before the Fed meeting on Wednesday and the results put the FOMC in a corner when it comes to defending against inflation (details below). More economists are now calling for a 0.25% rate increase next week and are calling into question the credibility of the Fed if it doesn’t happen.
Yields Are Moving Higher
The bond vigilantes have emerged as oil prices have remained elevated for too long to be ignored. Eventually, transportation costs will begin flowing through to final goods and the elevated PPI gave evidence of that this week.
Below is a chart of the 10Yr Treasury back to the COVID era low in 2020. You can see that we made a high in 2023 and traded sideways for three years. Now, the next leg higher is underway and we should be moving up to the mid 5% area.
The Yield Curve Is Steep
Over the past year, the shape of the yield curve has changed greatly as we have gone from inverted to steep. A normal curve is steep (blue line) and good for banks and finance companies as they have an incentive to lend out further on the curve. It can also signal a growing economy; however, the steepening process today reflects rising inflation expectations.
The artificial intelligence build-out has also caused massive debt issuance out the curve which also causes bond investors to demand higher compensation. So, if you combine corporate debt issuance, high energy prices and government deficits you get higher bond yields and unfortunately these moves can come abruptly.
If you examine the gap between the blue and orange lines in the chart, you will see the move over the past month, and it is most pronounced in the 1-3Yr part of the curve. Will the Fed follow the bond market and raise next week?
Reviewing The CPI and PPI Reports
The PPI (Producer Price Index) for final demand rose 0.4% for the month and 5.4% year-over-year. The CPI (Consumer Price Index) rose 0.4% for the month and 3.4% year-over-year. Both reports point to energy as the primary driver of headline inflation while the underlying components tell a more mixed story.
PPI Details
Final demand goods advanced 1.1% in August, with energy prices up 4.2% accounting for more than three-quarters of the increase. Diesel fuel jumped 24.1% and was the single largest contributor. Core PPI — excluding foods, energy, and trade services — rose 0.3% for the month and 4.7% year-over-year.
CPI Details
The CPI came in largely as expected. Gasoline rose 3.9% and accounted for more than a third of the monthly increase. The energy index was up 2.1% overall. Core CPI rose 0.3% for the month with the annual rate at 2.4%. Shelter increased 0.3% — consistent with the moderating trend — and stands at 3.0% annually. Food was up just 0.1% with food at home flat.
Where prices are rising:
- Gasoline: +3.9% MoM in CPI, diesel +24.1% in PPI.
- Transportation and warehousing services: +2.3% in PPI.
- Airline fares: +2.7%, lodging away from home: +2.4%.
- Communication services: +2.3%.
Where prices are flat or falling:
- Motor vehicle insurance: -0.8% (second consecutive monthly decline).
- PPI trade services margins: -0.2%.
For Next Week
The takeaway from both reports is that energy continues to be the dominant force in headline inflation. The PPI’s 5.4% annual rate is elevated, but the CPI at 3.4% has actually decelerated from its 4.2% peak in May. The categories that the Fed can influence through monetary policy — shelter, services, goods are either moderating or flat. The one category it cannot influence is energy and that is still running hot.
At the last Fed meeting, three voting members of the FOMC voted for a rate hike so that list is likely to grow. A 25bp hike will not change anything in the economy but the messaging around an increase could keep long bond yields from becoming unruly. Fed Chair Kevin Warsh is determined to remove such forward guidance but he may have to compromise next week to keep long bonds under control.
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