Canada Markets
A Relief Rally in US Treasury Markets May Be Just Providing False Hope
You know how you deal with a stressful event coming up by preparing for the worst while hoping for the best, then are relieved when it wasn't as bad as feared? That pretty much sums up how financial markets went into the Producer Price Index (PPI) and Consumer Price Index (CPI) reports out Tuesday and Wednesday, respectively.
When they weren't as bad as expected, a relief reaction resulted across the board: U.S. Treasury markets jumped, resulting in interest rates backing off. Treasury prices and interest rates are inversely related -- a higher rate of return is received by paying less for a fixed rate bond. Equities surged, and the U.S. dollar fell.
But will the celebration be short-lived on false hope?
Just like in December, the latest inflation figures have been initially met with relief by financial markets with details as expected or better. Headline CPI rose by 0.4% on a monthly basis -- as expected -- but above last month's 0.3%. On an annual basis, headline CPI rose 2.9%, again as expected but still above last month's reading of 2.7%. Therein lies the problem -- as expected, so a relief -- but still trending higher. Core CPI provided even greater comfort, coming in below expectations for both monthly and yearly figures. Core CPI rose by 0.2% on a monthly basis and 3.2% on an annual basis, down from 0.3% and 3.3% as expected, and last month's values -- providing the only promising sign that the trend higher may be stalling.
PPI results were similar with details not as bad as expected but still showing inflation trending higher. The headline number rose by 3.3% on an annual basis, below 3.5% expected, but above 3.0% reported last month. Again -- a relief but still trending higher. Core PPI had a similar pattern with gains of 3.5% annually versus expectations of 3.8%, but above last month's 3.4% annual gain (revised up to 3.5% Tuesday).
If I haven't lost you in the details, let's return back to the big picture. Inflation is still trending higher, yet the U.S. Federal Reserve can look at the misses compared to expectations as justification for further rate cuts. That outcome was immediately being priced into Fed Fund futures markets, now back to expecting another two quarter-point rate cuts for 2025.
Such a reaction is exactly what has caused the divergence in the Fed Funds target rate and long-term interest rates recently and why more of the same may be in store, thus the false hope concern. Treasury markets have been trading as if the lower the federal funds target rate, the more likely inflation continues to trend higher, and the higher the interest rate will need to be on long-term Treasurys to allow a desired real rate-of-return on investments. And repeat.
Political considerations don't help either -- keeping in mind this is in no way political, simply pointing out facts. President-elect Donald Trump's plans may end up adding to inflationary pressure if enacted as promised. Tariffs are almost certain with the debate being over their long-term impact on inflation or simply a one-time bump. Wage inflation would be hard to avoid should there be mass deportations as promised. Extending tax cuts would theoretically add to disposable income and thus inflation. And last, but not least, a Federal Reserve that could lose its independence could also have limited ability to maintain interest rates high enough to limit inflationary pressures.
Energy markets are not giving anyone warm and fuzzy feelings either, given the $12/barrel rally since Dec. 6 for the March crude oil futures. Heating oil (ultra-low sulfur diesel) has not fared any better with a 20% gain in value over that time. Gasoline futures are only up 13% while natural gas has increased 31.9%. You can thank cold weather in the United States and Europe and a surprising announcement from the U.S. Treasury Department, imposing further sanctions designed to reduce Russian energy exports, for much of the gains. But what happens should tensions escalate with Iran, for example? See more on the risks of a low Strategic Petroleum Reserve at https://www.dtnpf.com/….
Wage inflation can be one of the stickiest and hardest to control if it begins to accelerate with the recent payroll reports doing little to help relieve concerns there. The U.S. non-farm payroll report released Jan. 10 was much stronger than expected on all fronts: Far more jobs were created than expected in both payroll and household survey versions. Also, the unemployment rate fell unexpectedly.
Prior to the report and after a weak December household survey, the Fed had signaled concern over a weakening labor market being a risk. That has certainly been dismissed by the market for the time being.
So, what now? It will be important to see Treasury markets maintain the bounce off long-term support seen on the accompanying chart. Should the reaction rally fade quickly, a break of that support would not be a good look with little support found until the October 2023 low.
Regarding the impact on commodities, as discussed in the Commitments of Traders blog (see link below), this is exactly the worst-case scenario that the commodity index traders (CIT) are worried about: a Federal Reserve that downplays inflation at the most critical time -- early in the resumption of another potential run higher --- and still cutting rates while inflation continues to trend higher.
Should they (CIT) repeat their strategy from four years ago, they will be buying commodities as a hedge against it with relatively cheap grains and oilseeds a prime target. Besides watching for unexplainable strength in those markets, we will monitor the weekly supplemental report to track their actions. So far, we have seen sharp rallies in grains, oilseeds, and energies that were somewhat unexpected. With these being recent events, they have not shown up to any degree in CIT net-long positions to date, but rest assured that we will be watching.
More information can be found in previous blogs at:
-- "That '70s Show: Inflation Edition," https://www.dtnpf.com/…
-- "Commitments of Traders Data: The More You Know, The Better," https://www.dtnpf.com/…
-- "The 1970s Inflation Cycle Similarities Are Affecting Markets With More to Come," https://www.dtnpf.com/…
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I welcome feedback along with any suggestions for future blogs. My daily comments can be found in Plains, Prairies Opening Comments and Plains, Prairies Quick Takes on DTN products.
Mitch Miller can be reached at mitchmiller.dtn@gmail.com
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