The hotter-than-expected PPI numbers yesterday were followed by even hotter CPI numbers this morning and that has spooked the Treasury market into a decent back-up in yields, and with the CPI numbers this morning the move could have a little legs to it. Mind you, the back-up in yields is less about a fear of gathering inflation and more taking away the deflationary scenario. Even so, the backup in TIPS breakeven rates to within 17bps of 2019 highs has been noticed, as has the decline in the dollar to a more than two-year low on the spot index. So parts of the market are sniffing inflation and it took time before those moves started to resonate with nominal Treasury yields. We still believe a sustained move higher in inflation will be tough to come by given the demand destruction of 10.2% unemployment, and diminishing fiscal stimulus. Thus, we see this backup as having limited momentum and would look to add to positions should it move higher and into the pandemic-range high of 0.90%. The 10yr is currently 0.68%, up 4bps from yesterday’s close. Plenty of support, however, exists between 0.64% and 0.90% in the form of Fibonacci levels and 50- and 100-day moving averages. It’s timely that this week’s podcast features economist Joe Keating, Co-Chief Investment Officer at NBCS Asset Management. In the episode, Joe discusses his outlook on the economy, on rates, and on stocks. Give it a listen, and even better subscribe so you don’t miss any of our future episodes. The iTunes link can be found here and the Spotify link here.
We talked above about parts of the market perhaps catching whiffs of inflationary forces while the nominal Treasury market remained relatively unmoved until the hotter-than-expected July PPI and COPI prints. The graph below tracks the 5yr and 10yr TIPS Breakeven rates. The upswing since the March lows is rather unmistakable but still below the pre-pandemic levels.
Treasury Inflation Protected Securities (TIPs) are Treasury securities with an ultra-low coupon but with additional compensation based on changes in the CPI. Given the price of a TIPs security one can tease out the implied inflation rate, or compensation, that the investor is assuming given his price. As the graph shows, there has been a steady march higher in breakeven rates since the March low but it’s been more about removing the deflationary scenario than concerns about increasing inflation as we’re still below the pre-pandemic levels of last year and early in 2020.
Trade-Weighted Dollar Index Explained
In addition to the climb in breakeven rates, much has been made of the decline in the dollar since the spike in March during the pandemic-inspired volatility. That’s another inflation-warning sign. Of course, much of the argument for the severity of the decline is based on the spot index which measures the exchange rate between the dollar and major world currencies without weighting the trading relationship between those currencies. That index has indeed seen a dramatic decline to two-year lows. However, when one trade-weights the dollar against the major currencies, the decline is less severe. The graph below tracks the trade-weighted dollar index, and as shown, the dollar’s fall has been less dramatic, reaching a level last visited in March, prior to the spike in the dollar as the developing pandemic induced all manner of financial volatility.
As mentioned, this index weights the currencies by the relative value traded between them putting more weight on those currencies that have a greater trading relationship with the dollar rather than just a simple average drawn across a basket of currencies. It’s a more representative depiction of the relative change in trading value, which is what we’re really after. While some will flash the spot index and the drop to a two-year low, the trade-weighted index portrays a less dire scenario. Thus, between the increase in breakeven rates and the modest drop in the dollar we again think it’s more the deflationary scenario being taken off the table rather than a true fear of gathering inflation. Thus, any backup in yields from these developments will likely be limited.
Agency Indications — FNMA / FHLMC Callable Rates
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