The direction of inflation has been a topic of debate for several months and something we have written about for over a year. Until recently, the market and economic data had suggested that the rate of change for inflation would be positive. The November Consumer Price Index (CPI) made a new multi-decade high of 6.8% while the monthly rate of change slowed slightly to 0.8%.
Examining the components of the CPI report, along with some of the market signals related to inflation, reveals signs that the rate of change for inflation likely may have peaked.
The strongest monthly increases in the November CPI report were energy components.
The energy category increased 3.5%, down from 4.8% in October. Fuel oil decreased from 12.3% to 3.5% and energy services decreased from 3.0% to 0.30%.
Oil prices (WTI) have increased in the month of December but remain well below the October highs.
Natural gas prices have continued to decline in December and are close to 40% below their October high.
Vehicle price increases have also been a large contributor to CPI, partially related to a lack of vehicle production. Used vehicle price growth slowed in November and new vehicle price growth was unchanged. The bi-monthly Manheim index decreased in the second half of November. This could be related to a reacceleration in vehicle production as domestic auto production in October (latest figure) increased to 119 from 84 in September.
One other area that has been putting upward pressure on inflation is shelter. Much of the recent acceleration has been the increase in apartment rental rates. Many of the lowest rental rates were put in place in the second half of 2020 and those have now been replaced. Future renewals will start to take place from higher base levels, which will work to slow the rate of change in 2022. There is evidence that this is taking place in some of the sunbelt markets that have been experiencing strong rental growth (the relocation to other areas will also likely slow in 2022).
Market signals are also providing signs that investors expect inflation to likely decelerate in 2022. The yield on the U.S. 10-year Treasury is up from the lows of last week but remains well below prior highs and declined on the day of the November CPI report.
Two-year Treasury yields also declined on the news of the November CPI report, which suggests investors expect a less aggressive need for rate increases to address rising inflation.
The 10-2-year U.S. Treasury curve has steepened from the recent low but is well below prior highs and is unchanged from the start of 2021.
Inflation breakeven rates (investor measure of future inflation rates) continued to decline last week and the spread between five and ten-year levels continues to narrow.
Inflation swap spreads also continued to decline and the spread between five and ten-year levels continues to narrow.
The five-year, five-year, which is a measure of investor expectations for five year inflation rates five years in the future, peaked in October and is well below the levels reached in 2012-2014 when CPI was below current levels.
Expectations for future short-term rates have also been decelerating. The forward market for one-month overnight index swaps (OIS) peaked in late November, and the three-year expectation remains below the two year.
Another way of looking at future short-term interest rate expectations is the Eurodollar futures market. The futures curve has become very flat compared to a few months ago and still has a slight inversion.
These expectations for short-term interest rates suggest that investors think any increase in the Fed Funds rates will only last for a short period and will have to reverse course at a low absolute level.
The components that have been driving the acceleration in the CPI are showing signs of slowing and market signals are confirming that investors expect inflation to likely decelerate in 2022. This likely means a period of lower interest rates, flatter curves, and lagging returns for commodities.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Senior Vice President, Investment Strategy
Boyd Watterson Asset Management, LLC