Markets are moving in a way that would have seemed implausible at the start of this year: The U.S. reported that consumer prices are rising much faster than economists expected, and long-term Treasury yields fell in response.
The consumer-price index rose at a 0.9% pace for June, the quickest single-month rise since 2008, while economists had expected a 0.5% rise. While the annual CPI increase was boosted in part by comparison to last year’s slump in prices, it still came in at 5.4%, above forecasts for 4.9%.
Expectations for soaring consumer prices and strong growth are what fueled the Treasury-market selloff in the first quarter, when U.S. bonds posted their worst performance since 1980.
But now the price increases are showing up, and the market is hardly budging—a reflection of the expectation that Fed policies will lead to a slower path of inflation and growth over the long term. On Tuesday morning the 10-year yield fell one basis point, or hundredth of a percentage point, to 1.36%, well below its peak of 1.75% from the end of the first quarter. The 30-year yield fell two basis points to 1.97%.
While that sounds counterintuitive, it fits with one market narrative: Investors and traders expect the Fed to move sooner to tighten policy, putting a lid on inflation risk and reducing the compensation that investors demand for it over the long term. Futures markets are now pricing in a rate increase at the end of 2022, according to Bloomberg data, compared with early 2023 previously.
That was reflected across shorter-term—read: more rate-sensitive—Treasury markets as well. While longer-dated yields declined, the 2-year Treasury yield rose 2 basis points to 0.25%, implying that investors were betting on tighter Fed policy in the coming two years. The bond market’s 2-year inflation pricing soared nearly 14 basis points, or hundredths of a percentage point, to reflect a 2.8% breakeven rate, or the rate of inflation at which two-year Treasuries and Treasury Inflation-Protected Securities would be equally attractive.
Some Wall Street strategists seem less convinced that the central bank would take a more hawkish approach, however. TD Securities, for example, pointed to the contribution of reopening plays in the travel sector, as used-car prices rose more than 10% for the month.
“The pattern is consistent with strengthening being largely, albeit not necessarily entirely, transitory,” they wrote. “In any event, the transitory debate is unlikely to be resolved for a while.”
In other words, investors have plenty of fodder to keep debating whether the price strength is going to pass, or whether it is the start of a broader trend. On one hand, the strength in used-car prices and airfares as signs that some of the pressures could be temporary. Yet strategists at Jefferies pointed to stronger “owner’s equivalent rent,” what homeowners think they could charge to have renters live on their property. Rising costs of shelter could offset any reversal in used-car prices, they argued.
Bond prices seemed to take a pretty clear view that the Fed will respond to price pressures, however, and that raises questions about the central bank’s approach to inflation. In 2019 it decided to target average inflation, in effect allowing hotter inflation to make up for consumer-price slumps of the type that occurred during the pandemic, and New York Fed President
discussed that shift again in a Monday speech.
If the Fed decides to recommit to that strategy by waiting longer than the market expects to raise rates, that could mean more interest-rate volatility in the future, strategists at
“The market reaction is less on board with the transitory theme and more focused on the Fed reacting somewhat proactively to rein in inflation,” they wrote in a Tuesday note after the report. “Today’s print points to more communication challenges ahead for the Fed. We think the Fed will try to maintain a mantra of patience, but will be fighting a market that has not completely bought in to its new [approach to inflation]. This should contribute to heightened volatility in macro markets going forward.”
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