Today's CPI report showed the index rose 0.4% in August and 3.4% annually, in line with expectations. But stripping out volatile food and energy prices, core CPI rose 0.3% on the month. This is after readings of 0.2%, 0.0% and 0.2% in the last three months indicated inflation may be cooling. Oil prices are near $100/barrel (up 8% this week) as hostilities between the U.S. and Iran heat up with no signs of peace talks. The national average for a gallon of diesel rose to a record $6.06 on Friday, up more than 60% from $3.71 a year ago. The August CPI report doesn't capture new inflation pressures over the past week, so markets are anticipating another spike in the September report. Yesterday's PPI release (wholesale prices) indicated final demand energy prices rose 4.2%, pushed largely by soaring diesel prices.
Treasury yields continue to climb with the 10-year nearing the "psychological red line level" of 5%. This week's increased Treasury buyback program (tripling the amount to $6 billion) did not calm markets. The U.S. Treasury regularly purchases older long-term Treasury Bonds (10-, 20- and 30-year terms), which increases market liquidity. But this week's action failed to rally markets, and yields actually increased during this week's purchases as the $6 billion operation is tiny relative to the roughly $32 trillion Treasury market. Also, some investors may have interpreted Treasury's high-profile actions as a sign that strains in the Treasury market may be more severe than assumed. The 2-year Treasury (which tracks the Federal Reserve rate) spiked to 4.62% (up 50 bps since July 1). With the Fed rate at around 3.62%, this indicates multiple rate hikes are anticipated.
Today's PPI data and continued pressure on energy prices seemed to convince markets that a quarter-point Fed rate increase is a near certainty at next week's meeting. New Fed Chair Warsh's "inflation credibility" is on the line after his definitive statements at the recent Jackson Hole symposium (2.0% PCE target is a "hard line," the Fed is committed to controlling inflation, etc.). The futures markets indicate a 90% chance of an increase at next week's highly anticipated Fed meeting and about a 70% chance of two hikes by December, putting the rate at about 4.12%. What's at stake? Diane Swonk, KPMG Chief Economist, lays out a scenario if the Fed fails to act in time: "The bond market will overshoot, because investors will demand more of a premium (on Treasuries) if they begin to doubt the central bank's willingness to contain inflation." "The Fed controls the short end," she added. "The bond vigilantes control the long end." Stay tuned...
Chart of the Day — 10-Year Treasury and Cap Rates. Source: AXCS Capital, compiled from CBRE and CBRE Econometric Advisors data.
By David R. Pascale, Jr., Senior Director at George Smith Partners.
