The April CPI Report put a bid into Treasuries yesterday as the weaker-than-expected numbers dimmed some of the “inflation-is-building” narrative. But even as the core rate decelerated for a third straight month, the numbers probably weren’t weak enough to slow the Fed’s quest to hike at least three times this year. As a result, the Treasury curve flattened further as the long-end rallied on the absence of inflation momentum while the short-end remained stuck near current levels with the idea the Fed will remain on its hiking schedule. Given the curve flattening, we explore in more detail below what that might mean in regards to the Fed ending its tightening campaign (hint: it may be sooner than you think). In any event, today’s releases won’t be as consequential with Import Prices and University of Michigan Sentiment the only two on the docket. No, the focus will turn quickly to Tuesday’s Retail Sales numbers to gauge the consumer’s appetite for more consumption, and if the real wage numbers from yesterday are any indication increased spending may be a challenging notion (more on that below). Currently, the 10-year note is flat in quiet trading with a yield of 2.96% and that’s after trading through 3.00% mid-week. With the soft CPI numbers and a bullish turn in seasonality for the summer, we’re also mildly bullish with thoughts the 10-year could re-test the mid-2.80% levels.
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The big release of the week was yesterday’s April CPI report and in almost all respects it came below expectations. That, in turn, dialed back some of the building anxiety that inflation may be gathering momentum to the point it forces the Fed into a faster pace of hikes. The headline print was up 0.2% (0.221% unrounded) on a month-over-month basis versus 0.3% expected. The year-over-gain moved up from 2.4% to 2.5% matching the forecast. Meanwhile, the more important core-CPI reading came in at +0.1% (0.098% unrounded) versus the 0.2% forecast and the March and February result. Year-over-year core-CPI stayed at 2.1% for a second straight month but was below the 2.2% forecast. Also, the 3-month annualized rate was 1.8%, the lowest in these terms since July 2017. Finally, given core-CPI runs about 30bps above the Fed’s preferred inflation measure, core-PCE deflator, the CPI report signals the Fed will still be shy of the 2% benchmark when the PCE numbers are released on May 31.
Within the details of the core reading, Owners Equivalent Rent (OER)/shelter expense kept the rate in positive territory as it rose 0.3% for the second consecutive month. Weakness, however, in other categories held the core gain to 0.1%, which in turn limited the gain in the overall print. Dips in auto prices (new and used), cable/satellite services, and home utilities kept the core rate below expectations, but almost all core categories away from OER/shelter expense were relatively tame.
In addition, twin factors driving the “inflation-is-building” narrative seemed to have faltered this month. First, dollar weakness that prevailed throughout 2017 was supposed to drive import price inflation, and while goods prices have reversed their deflationary trend from last year, a recently stronger dollar will dull any further inflationary impulses in this area. Second, higher energy costs were expected to flow into other categories causing a creeping up of numerous categories, and, to date, that has not been the case. In fact, the flow-through into other categories has been limited and the higher costs for gas, etc., could instead be limiting consumer spending in other categories.
Part of the that resistance on the part of consumers to stomach a flow-through of higher energy prices may be that we saw real average hourly earnings drop to just 0.2% year-over-year after the CPI report. That’s the lowest reading since March 2017 (0.1%) and yet another indicator that real wage gains are proving elusive. So we’re not only not seeing enough wage gains to stoke demand-pull inflation, there is the concern that even the modest inflation gains we are experiencing, with the limited wage gains, are limiting consumers' purchasing power.
Overall, the price and wage data yesterday certainly won’t encourage the Fed to accelerate their plans for 25bps rate hikes on a rolling three-month basis. Then again, the data won’t deter the Fed from a June hike, and they still could engineer a four-hike 2018, assuming the data doesn’t materially soften. But yesterday’s numbers support our near-term bullish bias for the Treasury market and the seasonality factor also turns bullish with the conclusion of this week’s auctions.
The Treasury market absorbed new supply this week on the long-end, and did it without undue indigestion. While the10-year moved over 3.00% briefly for a second time this year, it didn’t approach the previous high of 3.03%, and with yesterday’s numbers it at least pauses the thoughts of needing to build in additional term premium due to enhanced inflation risks. In the meantime, nothing in the CPI report seems severe enough to cause the Fed to pause which means we’re looking at Fed Funds ending the year at either 2.25% to 2.50%. With the modest inflation impulse and bullish seasonality, the long-end is likely to find any yield back-ups grudging at best. Thus, assuming the 2-year Treasury remains at 50 to 75bps above Fed Funds, a flat to inverted 2yr-10yr curve seems likely by year-end and that could force the Fed to pause given their rhetorical reluctance to induce an inverted curve.
Treasury 2yr-10yr Yield Spread
Treasuries have traversed a tricky week that saw over $70 billion in new Treasury supply come in the form of 3yr, 10yr, and 30yr maturities. The market managed to take down the new issuance without too much indigestion. Despite a mid-week foray back to 3%, 10yr yields managed to finish the week about where they started. The weaker-than-expected CPI also flattened the curve further to 43bps as shown in the graph. At the same time, ongoing labor market gains probably keep the Fed on track to hike three to four times this year. If the 2yr yield remains 50 to 75bps above the Fed Funds Rate that would put the curve at or near inversion. Given the Fed’s professed aversion to this it could give the Fed reason to pause its hiking campaign.