We have been monitoring the inflation setup closely given its potential impact on the path of interest rates and monetary policy over the next few months. A re-emergence of higher Headline inflation prints could lower the pace and magnitude of rate cut expectations and keep the long end of the Treasury yield curve elevated.
Last week we received updates on inflation via the Consumer Price Index (CPI) and Producer Price Index (PPI). At the Headline level, both series continued to decelerate y/y, with CPI inching lower to 2.4% and PPI slowing to 1.8%. Excluding food and energy, Core CPI and Core PPI accelerated sequentially for the second month in a row to 3.3% and 2.8%, respectively. The recent divergence of Headline and Core inflation growth is worth highlighting given the shifting comparison set for energy in the fourth quarter and what that could mean for rate cut expectations.
Source: Macrobond
Focusing on the energy piece of consumer inflation, the New York Harbor RBOB Gasoline end-of-month average price is $2.08, through the first twelve trading days in October. To keep the math simple, if gasoline stays at $2.08 for October, the y/y growth rate will accelerate to -8.5% from -25.2%. That rate of change acceleration should lift the contribution from Motor Fuel higher (less subtraction from Headline CPI growth). With Core CPI growing at 2.8% y/y, a reacceleration in energy likely keeps Headline CPI north of the Fed’s 2.0% target through the fourth quarter.
Source: Macrobond
While we monitor that dynamic through the next set of inflation releases, the path of the U.S. Dollar Index (DXY), U.S. 10-year Treasury yield, and 5-year break-even inflation rate can provide daily signals for the most likely path of inflation and monetary policy expectations in the near term. At the time of writing this, the U.S. Dollar Index is sitting at 103.39, up 3.1% from its recent cycle low made on September 24th. This is important because it is likely an indication that there may be rising expectations for the FOMC to remain more hawkish than its global central bank counterparts.
Source: Koyfin
Turning to the U.S. 10-year Treasury yield, we have seen some yield give back in the last two days, but it remains north of 4% after rising from its September 16th cycle low of 3.62%. If rate cuts were going to undershoot expectations relative to the aggressive path previously being priced in, we would not expect to see long-end rates fall meaningfully below that prior cycle low in the near term. With that said, it is worth mentioning that interest volatility has picked up in October and could remain elevated going into the U.S. Presidential election.
Source: Koyfin
Source: Macrobond
Lastly, the 5-year break-even inflation rate has come down over the last two days to 2.22% but remains 36 basis points higher than its cycle low made on September 10th. The relationship between Headline CPI and the 5-year break-even inflation rate is not one-to-one but has historically been a helpful tool for gauging expectations for a shift in the direction of CPI growth rates.
Source: Koyfin
Source: Macrobond
The takeaway from an acceleration in Core inflation measures, easing of energy comparisons, and three market signals laid out above is that they have moved in a direction we would expect if Headline CPI were to stay elevated and rate cut expectations were to get pushed out. We will continue to provide updates on this dynamic as more data becomes available.
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.
Investment Strategist
Boyd Watterson Asset Management, LLC