Record Inflation? Bond Yields Disagree
Another reading of consumer inflation has made a new record, this time with an almost 30 year high. Core PCE, on a year on year (YoY) basis for April ‘21 came in at 3.1%, which is the highest reading since 1992! While this makes for an undoubtedly eye-catching headline, and adds even more fuel to the popular “the economy is overheating” narrative, what do markets make of it?
Firstly, it is important to note that core PCE stands for core Personal Consumption Expenditures. Core here simply takes out the food and energy price components from the PCE calculation as these tend to be very volatile. Hence, the core number shows us how consumer expenditures are trending, which is exactly what needs to be tracked in order to ascertain if the economy is generating “good” inflation.
More importantly, the core PCE is the Fed’s preferred gauge of inflation. This makes April’s 30 year high in the core PCE more relevant than the record breaking CPI prints of the past few months.
Looking at the chart, it is quite clear that April’s core PCE isn’t like anything we’ve seen for, well, three decades. The economic recoveries post 2000 Dot Com bubble and 2008 Great Financial Crisis did not produce such highs. Not even the years in the lead up to ‘08, where US housing was booming, produced such highs; unless of course we consider base effects, fiscal largesse and supply chain disruptions.
Which at this point are issues that have been raised so often that they sound like a bad excuse. Unfortunately, sounding like a bad excuse does not make them any less relevant or valid when trying to interpret current economic data.
However, since we now have had a few months of crazy inflation data, we no longer have to keep the inflation discussion centered on how base effects are skewing recent data, we can simply look at what the bond market is doing.
Starting with US breakeven rates, we can see that they have turned down a little over the past couple of weeks, after rallying higher since dipping in April. What is curious, and for those more prone to worry, a matter of concern, is that the breakeven rally has stalled even as inflation data continues to come in way above consensus expectations.
Whether breakeven rates continue downwards is a matter of wait-and-see, but for now, we will need to look at something else to provide a more conclusive picture, like USTs.
Looking at nominal UST yields, we see the same situation as with breakeven rates – the rally has stalled out. However, the rally in UST yields topped out about a month earlier, in April, and has since traded in a range first established in March. That’s three months of yields going nowhere, even as narratives have raged about inflation and economic overheating. This is important, because it was the sharp rally in 10 year yields back in January of this year that sparked the reflationary narrative in the first place!
In addition, the US Treasury market just isn’t trading in a way that comes close to reflecting the inflation hysteria being reported. Look at the levels at which the rally has stalled, that’s between 1.6% to 1.7% in the 10s, and 0.8% to 0.9% in the 5s. Considering that the 10s have barely regained their pre-Covid levels, and the 5s remain really far away from where they were in Jan 2020, these levels are not impressive on an absolute basis; and much less so when taken in context with record breaking inflation data.
Perhaps there is something to all that talk about base effects, fiscal largesse, and supply chain disruptions after all.
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