Inflation update could be the circuit breaker for USD
- A strong CPI number to back up the jobs report could get USD moving again
- investors are turning a deaf ear to Fed promises that 2% inflation is near
- There’s a chance base effects will drag US headline inflation to the Fed’s target
By Max McKegg
Today in the US we get the key data releases for the week: Retail sales and the Consumer Price Index. Inflation and employment represent the Federal Reserve’s dual mandate, and a strong CPI number to back up last Friday’s jobs report could trigger the circuit breaker needed to get the USD moving again.
Perhaps sensing a change in sentiment, bond yields have jumped in the last few days and the odds of a Fed rate hike by year end have increased from near zero to 40%.
Markets may also be pricing in the base effects that will kick in over the next few months, possibly pushing inflation up to the Fed’s target by year end.
Last month’s update showed headline CPI running at 1% year-on-year and the core rate at 2.2%. The chart below shows the long term history of the CPI.
The Fed is wanting the headline rate (the red line) to catch up with core rate (blue line).
The Fed uses the headline rate as its benchmark because it’s the best measure of the cost of living for consumers and therefore guides inflation expectations. The core rate is of more interest to economists.
Headline inflation (which includes energy prices) won’t catch up with the core rate (which doesn’t) until base effects kick in - that is, until the impact of oil price falls a year ago drop out of the annual calculation.
Today West Texas Intermediate is trading at around $45/barrel. The chart below shows how the base effect will come to the rescue if oil can hold that level.
In this scenario, headline inflation in the US would hit 2% by year end with, of course, the caveat: All else being equal. All else won’t be equal if, for example, the US dollar were to rise materially, thus lowering import prices.
With quite a few balls in the air, the Fed has made it quite clear the journey to interest rate normalisation won’t resume until they are staring inflation in the face.
That’s because studies are showing actual inflation is having a more significant influence on medium-term inflation expectations than in the past.
The bond market seems to agree: The yield on the 10-year US Treasury issue is 1.50% and investors are turning a deaf ear to Fed promises that 2% inflation is just around the corner.
This is a log chart of the great bull market in bonds that began in 1981 when the fed funds rate was 20% and the 10-year yield 15% plus (Click to enlarge).
Notice how the big moves have come in recent years as deflation rather than inflation was seen as the bigger risk.
But all bull markets reach an exhaustion point at some stage, even 30-year ones.
Breaking down the yield on the current 10-year Treasury bond into its components helps to explain why this one might be on its last legs.
In the chart below, the “risk neutral” rate, which can be considered the market’s long term expectation for the federal funds rate, is represented by the yellow line. The fed funds futures curve rises towards 2% over the next ten years.
In normal circumstances the market adds a positive “term premium” on top of the risk neutral rate as compensation for the known unknowns of investing in long-dated securities.
if the federal funds curve was going in the other direction. Photo: iStock
A major one is the possibility of a spike in inflation. The term premium (the dark blue line in the chart ) is, therefore, the spread between the risk neutral rate and the actual bond yield.
Normally the spread is positive, but times haven’t been “normal” of late and the term premium has slipped below zero, in turn pulling the actual yield on the 10-year Treasury (the light blue line) down to 1.50%, under the risk neutral rate rather than above it. This is most unusual.
10 Year Treasury yields
What does a negative term premium tell us about the outlook for the US economy? Is it a hint of imminent recession as some suggest ?
As it turns out there’s a simpler explanation: The firm correlation between the term premium and the US-Germany yield spread.
As German yields have tumbled below zero the term premium attached to US bonds has declined in tandem. A similar (not quite as strong) relationship exists between US and Japanese bond yields.
This effect has been so strong that in theory it’s possible medium-term US Treasury bonds could rally further, perhaps towards 1%, even if the federal funds curve was going in the other direction.
But the main point is that the current flattening of the US yield curve is not foretelling recession. Instead it represents the growing inter-relationship between G3 bond markets.
The US dollar will not regain strength until the term premium turns positive and it looks unlikely that the German or Japanese bond markets are going to provide the spark.
So that leaves a home grown inflation jolt in the US, or perhaps a belated recognition that there’s a good chance base effects will drag US headline inflation up to the Fed’s target by year end.
Today’s CPI number probably won’t be a jolt, but with the bond market in the mood to sell off anyway, even a small beat might be enough to help it, and the USD, on its way.
-- Edited by Adam Courtenay
Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade, then click here to follow him