Ameriprise Financial : What's Behind the Renewed Focus on Inflation?

While most eyes were focused on equity earnings last week, the more interesting movements were taking place in the bond market. In what was an abbreviated trading week due to the Columbus Day holiday, Treasury yields continued to churn higher in an ascent that traces back to early July. The ten-year note yield ended the week at 1.79 percent, up seven basis points from the prior week. In just the first two weeks of October alone the yield has jumped 20 basis points. The yield is now back to where it was in early June, just prior to the disappointing May jobs report and before the surprising Brexit vote. But after a soft patch in August, more recently the economic data has firmed, inflation readings have turned higher and the Fed seems to be on a path to raise rates in December.

The Treasury two-year note has traced a similar pattern to the ten-year. After reaching its lowest yield of the year at 0.56 percent on July 5, it has since climbed to 0.83 to end last week, after hitting a recent high of 0.87 percent on Wednesday. The breakeven yield on the ten-year Treasury inflation protected security, or Tips, has also reached a recent high of 1.67 percent, up from its year-to-date low of 1.37 percent of June.

Economic Data Continues to Strengthen

The latest round of economic data has shown the economy to be firming after a series of uniformly disappointing reports from late summer. Last week, we learned that retail sales rebounded strongly in September after falling in August. That followed previously solid reports from the Institute for Supply Management (ISM) on manufacturing and services in September. The jobs report was also solid, and included a rebound in average hourly earnings. Motor vehicle sales were strong as well. And last week's release of the minutes from the Fed's September meeting confirmed that the decision not to raise rates was close, as clearly reflected by the three dissenting votes.

Inflation readings themselves have been edging higher recently. This week's economic calendar includes the latest report on consumer prices from September on Tuesday. In August, the headline Consumer Price Index (CPI) registered a year-over-year rate of 1.1 percent, up from 0.8 percent on July. According to Bloomberg, that rate is expected to jump to 1.5 percent with the September report, primarily due to the recovery in energy prices. But the core rate, (ex-food and energy) has been edging higher as well, hitting 2.3 percent in August, up from 2.2 percent in July and matching its yearly high from February. That rate is expected to have been unchanged in September.

The Fed's preferred measure, the Personal Consumption Expenditure (PCE) deflator, has also been firming. In August, its headline measure touched 1.0 percent year-over-year, up from 0.8 percent in July, while the core measure rose to its highest level in two years at 1.7 percent. And producer prices registered a sizeable jump in September, rising to a year-over-year rate of 0.7 percent from 0.0 in August, while the core rate rose to 1.2 percent from 0.7 in August.

Inflation Expectations Remain Low

Despite these moves, so far there has been little discernable change in inflation expectations. In the latest University of Michigan consumer sentiment survey the one year expected inflation rate remained unchanged at 2.4 percent, while the 5-10 year expected rate actually fell to 2.4 from 2.6 percent. The third quarter Survey of Professional Forecasters from the Philadelphia Federal Reserve showed little change to inflation expectations as well. Even the Fed's own latest economic projections from its September meeting showed little change to its expectation of inflation, and in fact, the median forecast for core PCE in 2017 was revised lower by 0.1 to 1.8 percent.

Nevertheless, this recently renewed focus on inflation has created a challenging environment for bond prices. For the month of October the 10-year plus Barclay's U.S. Aggregate index is down 2.3 percent. Longer maturity municipal bonds are also lower. But the ongoing reach for yield, combined with the aforementioned stronger economic data, has meant continued gains for lower quality bonds, as the Barclay's long corporate high yield index is higher by 0.7 percent in October.

Important Disclosures:
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances.
The Consumer Price Index is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. Changes in CPI are used to assess price changes associated with the cost of living.
The personal consumption expenditure (PCE) measure is the component statistic for consumption in gross domestic product (GDP) collected by the United States Bureau of Economic Analysis. It consists of the actual and imputed expenditures of households and includes data pertaining to durable and non-durable goods and services.
University of Michigan Consumer Sentiment Survey is a rotating panel survey based on a nationally representative sample that gives each household in the coterminous U.S. an equal probability of being selected. Interviews are conducted throughout the month by telephone. The minimum monthly change required for significance at the 95% level in the Sentiment Index is 4.8 points; for Current and Expectations Index the minimum is 6.0 points.
The Barclays U.S. Aggregate Bond Index is a market value-weighted index that tracks the daily price, coupon, pay-downs, and total return performance of fixed-rate, publicly placed, dollar-denominated, and non-convertible investment grade debt issues with at least $250 million par amount outstanding and with at least one year to final maturity.
The Barclays U.S. Corporate High-Yield Index measures the longer duration component of the USD-denominated, non-investment grade, fixed-rate, taxable corporate bonds. Securities are classified as high yield if the below, excluding emerging market debt.
The US Corporate High-Yield Index was created in 1986, with history backfilled to July 1, 1983, and rolls up into the Barclays US Universal and Global High-Yield Indices.
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