The outlook of interest rates high for longer because of a lousy inflation report is vying with peace talks in two places, Ukraine and Gaza, for the top factor. We saw the euro and other currencies do a quick about-face yesterday when the peace talks grabbed headlines, reversing the dollar gains from the inflation report and corresponding yield rise.
It’s rare for something geopolitical to trump serious economic and institutional inferences. The secret lies in the very concept of war. War changes everything. We saw it even before Bush II invaded Kuwait and before the US invasion of Iraq. It should be no surprise that the prospect of war ending has the opposite effect.
We calculate that the idea of Trump delivering anything real and lasting has little chance of succeeding for long..
We are still feeling the effects of yesterday’s CPI. It’s not so much the BLS reading of headline and core CPI higher, but rather the Cleveland Fed’s median up 3.9% annualized (from 3.59%) and core up 5.1% annualized (from 3.13% the month before). That’s the month before, not the year before.
The failure to thrive is down, again, to shelter. See the chart. As noted before, the housing shortage has multiple forces failing to deliver sufficient supply, including high contractor debt costs and mortgages. But prices gains are fairly broad-based, hitting insurance, used cars and trucks, airline fares, medical care, haircuts, day care, sporting events, concerts, cable TV, and other things (and not just eggs).
Some are panicking and saying the inflation story has now changed-0no longer getting better, if by inches, but set back, by yards. The bond market got spooked. The 5-year breakeven rose to 2.64%, the highest since March 2023 (nearly two years) and 78 points higher than just before the Sept rate cut. Wolf Street is alarmed.This is backwards if the bond market believed inflation was indeed falling. It means the 100 bp in cuts led to a 78 bp rise in expected inflation
*The 10-year breakeven is a little less anxiety-ridden but shows the same effect. The new built-in inflation rate is 2.46%, the highest since October 2023. It’s higher by 44 points since just ahead of the Sept rate cut.
Wolf Street is alarmed. “A Fed that is lax about inflation scares the bond market once inflation starts rumbling. And the Fed has seen that reaction from the bond market too – including the surge of longer-term yields, such as the 10-year Treasury yield, since the beginning of the rate cuts – which is why it has walked back any talk of further rate cuts and instead has pivoted into wait-and-see mode to not unnerve the bond market further.
“The bias today is still for cuts, not hikes. Inflation would have to make larger and more sustained moves higher for the Fed to switch the bias to rate hikes.
“But a bond market freakout over accelerating inflation and a lax Fed – resulting in higher long-term yields that really matter for the economy – would nudge the Fed to switch its bias to rate hikes again. To keep long-term yields from rising too much, the Fed will need to show the bond market that it’s serious about inflation, and that it will crack down again if inflation re-accelerates substantially.
“That’s the irony: The Fed might have to hike short-term rates again to make sure long-term interest rates remain ‘moderate’ – paying attention to the third part of its mandate, to conduct monetary policy ‘so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.’ The mandate is silent about the Fed’s short-term policy rates. It’s “long-term interest rates” that are in the mandate, and the way to get there is to keep inflation in check.”
Wolf may overstate the panic a little, and don’t forget that and end to war in two places has already driven the price of oil down and by a lot, from $82.83 on Jan 15 to $74.14 now and over 1% in a single day. See the energy price table from Trading Economics (below).
The next PCE reading is not due until month-end, and that’s what the Fed is supposed to be watching Yesterday Mr. Powell pointed out that components from the PPI that feed into PCE are high on the watchlist. He said “You need to know the translation from CPI to PCE, and we get more data on that tomorrow with the Producer Price Index…. we’ll know what the PCE reading is late tomorrow.”
There’s a tiny possibility that the next PCE reading will be far tamer than the CPI and there’s another small possibility that ending two wars will drive inflation down and growth up at the same time. How many smallish factors does it take to override a really bad inflation outlook? Nobody knows. At the moment, the probability of a rate cut is pushed out to the Oct meeting, according to Reuters.
Forecast
It was shocking to see the dollar recovery from the correction suddenly reverse course and by a lot. It seems unlikely that ending that war, plus maybe the Gaza war, too, would trump the fresh outlook for the Fed on hold even longer than we thought.
Whether ending the war in Ukraine is a real prospect will get more input from an international security conference in Germany on Friday and what Mr. Zelinsky has to say there. It’s not clear he gets to choose much.
We guess the war-ending story will persist for quite some time but in the end, will not overcome the relative rate differentials and higher US term premium. The Big Picture is still in the dollar’s favor, but remember, no straight lines in markets.
Tidbit: “The Associated Press said on Tuesday that one of its reporters was barred from an Oval Office event because the outlet has continued to refer to the Gulf of Mexico by its original name” (NYT).
Another failure to acknowledge reality: after the inflation data release yesterday, Trump repeated that “Interest Rates should be lowered, something which would go hand in hand with upcoming Tariffs!!!”
It’s clear that either Trump doesn’t have a clue about the relationship of inflation and the Fed’s mandate, or he is just lying to the public. It’s possible both things are true.
Fun Tidbit: The WSJ lets the cat out of the bag—”The Dow is an awful index that was designed for an era of human stock selection and slide rules and is horribly outdated in the automated age of index tracking.
“Professional investors mostly ignore the Dow, though they pay close attention to the Nikkei 225, Japan’s equally flawed index. Yet the Dow gets outsize attention in the media and among ordinary investors, presenting a distorted picture of what’s going on with America’s stocks.”
Big tech (the Magnificent Seven) “make up almost a third of the S&P 500. Moves in the S&P are dominated by whether it is a good day or a bad day for Big Tech. But in the Dow, these seven make up only 13.9%, with Meta, Tesla and Alphabet missing altogether.
“Instead, the Dow gives five stocks that barely matter to the market as a whole the same weight that the Mag 7 have in the S&P. Aside from Microsoft (third-biggest in the Dow, as in the S&P), the five-biggest Dow stocks are Goldman Sachs, UnitedHealth, Home Depot, Caterpillar and Sherwin-Williams. Together they are 32% of the Dow, but make up a tiny 2.6% of the S&P.
“What moves the S&P matters relatively little to the Dow, and increasingly what moves the Dow matters even less to the S&P. The reason for all this is a design decision that is bizarre today but made sense when the Dow was first compiled: It is weighted by price, not by market value. The higher the share price, the more a stock moves the Dow.
“This is even though the share price matters not at all in the real world. Moves in the price matter of course, but whether a stock is say, $62, like Cisco Systems, or $647, like Goldman, makes no difference. Price-weighting made it easier to calculate the index in the days before computers and easy access to corporate share counts, but it is an anachronism today.”
“On top of that, the Dow isn’t made up of the biggest companies, but is supposed to be representative of the U.S. An index committee at S&P Dow Jones Indices, part of S&P Global, decides which companies get into the index. The committee—which includes two Wall Street Journal editors—has often picked new members at exactly the wrong moment, including the addition of Microsoft and Intel shortly before the dot-com bubble burst. The S&P 500 itself isn’t perfect at representing the market, but it is vastly better than the Dow.
“The result is that the S&P and the Dow move in opposite directions more often than ever before. Since the S&P 500 was introduced in 1957, one rose while the other fell on average one day in 10. Now they diverge one day in four—higher even than during the frantic trading of the dot-com bubble in 1999-2000 or the bond-market massacre of 1994.”
So there. Now you know. Actually, this same story with different details appears every few years. We think we recall it from the late 1980’s.
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