Is the U.S. progress on inflation a case of two steps forward, one step back? Even before the stronger-than-expected September CPI report, bond prices were declining in the wake of the Fed’s jumbo half-point rate cut decision.
The Treasury market is exhibiting signs of anxiety from a technical analyst’s perspective. The 7–10-year Treasury ETF (IEF) has declined to test a key rising trend line. The long Treasury bond ETF (TLT) has already violated its trend line.
While the technical violations may only be temporary false breakdowns, these technical signals compel me to explore their asset return implications.
A Hot CPI report
Just when you thought that inflation was making good progress toward the Fed’s 2% target, the September CPI report came in higher than market expectations. Core CPI (blue bars) ticked up sequentially. Especially disappointing was the services CPI ex-rents print (red bars) that was unexpectedly strong.
After all, the September FOMC minutes contained the crucial assumption that “almost all participants judged that recent monthly readings had been consistent with inflation returning sustainably to 2 percent” and “Almost all participants saw upside risks to the inflation outlook as having diminished, while downside risks to employment were seen as having increased”.
Eleven of 12 FOMC members support a half-point cut as they “generally observed that such a recalibration of the stance of monetary policy would begin to bring it into better alignment with recent indicators of inflation and the labor market”. The lone dissenter was Fed Governor Michelle Bowman, who favoured a quarter-point cut.
So much for the assumptions. Was the hot CPI print just a data blip? How does it affect the rate cut path as the Fed has become more data dependent?
Even as the Fed strives to be predictable and communicate its policy path, excessive data dependency will make for more volatility in interest rate expectations. In the wake of the CPI report, the WSJ reported that Atlanta Fed President Raphael Bostic said in an interview, “This choppiness [in inflation data] to me is along the lines of maybe we should take a pause in November. I’m definitely open to that”. On the other hand, Bloomberg reported that New York Fed President John Williams, Chicago Fed President Austan Goolsbee and Richmond Fed President Thomas Barkin dismissed the hot CPI print as a data blip.
Now that inflation has come in higher than expected, the debate is no longer recession or soft landing, but soft landing or an overheating economy. The 10-year Treasury yield is now well above 4%. Expect Treasury yield volatility to continue until the market is satisfied that inflation is sustainably on its way to 2%. Moreover, the recent hurricane-related supply chain disruptions will also make judgments about the U.S. economy more difficult and more volatile.
Equity market challenges
In other words, bond market investors will face greater near-term uncertainty. But what about stocks?
Long-run equity returns depend on two key factors: the evolution of earnings and the capitalization rate of those earnings, or the P/E ratio, which is dependent on competing Treasury rates.
