Is the Fed Is 100 Basis Points Behind? Bonds Think So.
Friday’s inflation report came in exactly where Wall Street expected it, and the bond market sold anyway.
August CPI rose 0.4% for the month and 3.4% for the year, both matching consensus. Core CPI, which strips out food and energy, rose 0.3% for the month against a 0.2% forecast, and 2.4% for the year as expected. Headline matched. Core missed by a tenth. On paper, this was a “nothing report.”
Bonds disagreed.
The 2-year yield jumped to 4.655%, a two-year high, on a day when most of the curve staged a relief rally. The 10-year touched 4.973% overnight, dipped to 4.91% in the morning, and was back to 4.957% by 2 p.m. Two weeks ago I told you Treasury had a pain threshold in the mid-4.80s. Friday the market blew through it on an inflation print nobody was surprised by.
That’s a major signal. But the more concerning item pertains to the short end of the curve: the area the Treasury isn’t focused on.
The Fed’s target range is 3.50% to 3.75%, and the effective federal funds rate trades around 3.63%. The 2-year yield is the market’s estimate of where the funds rate will average over the next two years. With the 2-year sitting 100 basis points above the funds rate, the bond market is pricing at least four quarter-point hikes and telling the Fed it should have started already. In simple terms, the Fed is 100 basis points behind the curve.
The market has moved accordingly.
Odds of a hike at this week’s meeting went from a coin flip in August to 90% or better after Friday’s report. TD Securities now expects three hikes in this cycle. And this Fed does not need much convincing. Three regional presidents dissented in July in favor of an immediate hike, and Warsh used Jackson Hole to say getting inflation back to target was his primary job.
Gasoline accounted for more than a third of the monthly increase and is up 27% from a year ago. Fuel oil is up 52%. Brent crude is above $105 on the Iran conflict. The Fed spent the last year treating energy as a supply shock that would pass on its own. The core reading accelerating from 0.2% to 0.3% is the first clear evidence that higher energy costs are working their way into everything that moves by truck, ship, and plane. Capital Economics estimates core PCE, the Fed’s preferred measure, is now running at 3.4% and rising. That is what flipped Waller and the other centrists.
To be clear, 3.4% inflation is a long way from 2022. The economy is growing, payrolls are solid, and a Fed hiking into strength behaves very differently from a Fed hiking into a recession. I am not calling for a crisis.
I am telling you this is a major signal, and you need to see it alongside what Treasury has been doing.
Two weeks ago Treasury started buying back its own long-dated debt to push yields down. This week the Fed is set to raise short-term rates to push inflation down. One arm of the government is trying to make borrowing cheaper. The other is about to make it more expensive. Both are reacting to the same problem: peacetime deficits above 6% of GDP, inflation stuck above target, and an energy shock Washington does not control. Treasury and the Fed are pulling in opposite directions. Friday the bond market told you which one it believes. Short rates are going up. Long rates already did. Treasury’s $6 billion buyback did nothing to stop it.
For investors, the picture just got clearer.
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Best Regards,
Graham Summers
Chief Market Strategist
Phoenix Capital Research