July’s CPI reading came in pretty much as expected, at 3.2% versus consensus analysts’ estimates of 3.3%. But inflation swaps had this one priced right at 3.2% and should raise some eyebrows because the swaps are seeing inflation rising again in August to 3.6% y/y and then falling a touch to around 3.5% in September.
So yes, inflation continues to slow, but as far as the next couple of months go, based on market predictions, we will be moving further from the Fed’s 2% target. This probably means that rates on the long end of the Treasury curve will probably continue to head higher.
If the market is correct, then in August, we should see CPI rise by 0.6% m/m SA and rise by around 0.3% m/m SA in September. That will certainly throw off many people trying to annualize 3-months’ worth of data because if the swaps market is right. The 3-month SA annualized inflation rate will go from its current 1.9% to almost 4.5%.
But beyond September, the inflation outlook gets murky because swaps see December y/y CPI NSA at 3.1%, which means that after the rise in inflation in August and September, prices will have to make a hard right-hand turn, and actually begin to decline to meet the swap market objective.
What seems fairly clear is that headline inflation is likely to be in this 3% to 4% range, at least for the balance of this year, and that is only if oil and gasoline prices cooperate because if they should continue to rise, that obviously creates an upside risk to the inflation outlook.
Rates Still Seem Too Low
This probably doesn’t mean much for the Fed but could mean a lot regarding long-term interest rates. Especially if the uptick in headline inflation should lead to an uptick in core inflation if businesses begin to pass higher energy costs. For now, Bloomberg estimates that core CPI will fall to 4.2% by September from July’s 4.7%.
The 30-year trades for roughly 4.25% and is about 50 bps below the core CPI rate. So even if the core CPI rate falls as projected, the 30-year rate would still only be equal to the core CPI. From 2011 until 2019, the 30-year Treasury typically traded more than 105 bps higher than core CPI. That would suggest that the 30-year rate today trades around 5.2%.
Since 1977, this is the second period that has seen the 30-year rate trade below the core CPI rate. This is also the longest the 30-year Treasury has traded below the core CPI rate.
Of course, if core CPI came down to 3.2%, then-current levels on the 30-year rate would make sense. But the longer it takes for core inflation rates to fall, the more likely it is that the 30-year rate trades higher.
Higher Inflation May Be Coming
It is possible that when looking forward, the projected path of inflation from here may very settle into a sticky range because core goods and services remain elevated. July saw core goods fall some, but core services remained relatively unchanged.
Core services less housing, also known as super core, rose by 0.2% m/m, up from last month’s 0.0% reading. This also helped to push the year-over-year reading to 4.1% from 4.0% last month.
If oil and gasoline prices suddenly start to trade higher from current levels, it would ripple through the economy and could tack on month-over-month gains in inflation. So truly, until these core services and goods return to pre-pandemic levels, as we advance, inflation is likely to be a struggle to contain and is a strong reason why rates on the long end of the curve may need to climb higher.
The longer it takes for inflation to come down, the more likely it is that the rates on the long end of the curve will need to rise. It also means that the idea of the Fed cutting interest rates anytime soon isn’t likely to happen.