There were several inflation reports this past week, and they all had one thing in common: they didn't show a pickup in inflation. On the contrary, they revealed a slowdown in the pace of core inflation.
Put in economic terms, they revealed a budding trend of disinflation. Why, then, did long-term interest rates increase and expectations for a rate cut later in the year decrease?
Because the market found reason to think this budding trend of disinflation is going to be nipped in the bud.
Fading at the core
To begin, the Consumer Price Index (CPI) and Producer Price Index (PPI) reports for March produced some headline surprises that were nettlesome on the surface. Total CPI increased 0.4% month-over-month (Briefing.com consensus 0.3%) while the PPI for final demand jumped 0.6% (Briefing.com consensus 0.3%).
In both cases, energy prices were the driver of the upside surprises. Where things got a little more interesting were in the year-over-year changes for the core rates of inflation, which exclude food and energy.
Readers may not like the idea that the Federal Reserve ("Fed") keys off the core rates, knowing that energy costs and food costs claim a portion of consumers' income every month, yet the volatility in energy and food prices is what leads the Fed to place more of a premium on core rates of inflation.
The Fed's preferred inflation gauge is the core PCE Price Index, which accompanies the Personal Income and Spending Report each month (when it's not delayed by a government shutdown like it has been this year).
The latest core PCE price data only runs through January; nonetheless, that data showed core PCE price growth moderating year-over-year to 1.8% from 2.0% in December.
The CPI and PPI data are updated through March, but there was moderation there, too, with core CPI up 2.0% year-over-year, versus 2.1% in February, and core PPI up 2.4% year-over-year, versus 2.5% in February.
Staking a claim
Ostensibly, the moderation in the core rates of inflation should have sent the Treasury market, and particularly longer-dated maturities, which are more inflation sensitive, into rally mode. That did not happen.
Yields on the 10-yr note and 30-yr bond increased six basis points and four basis points, respectively, this week to 2.56% and 2.97%. To be fair, that still leaves yields lower from the start of the year when they stood at 2.68% and 3.01%, respectively.
The weakness, then, could simply be a case of selling the news after a big rally, yet there is some doubt as to whether that really was the case considering that the fed funds futures market lowered its expectation for a rate cut this year at the same time.
On Wednesday, there was a 58.9% probability of a rate cut at the December FOMC meeting priced into the fed funds futures market, according to the CME's FedWatch Tool. Today, the probability of a rate cut at the December meeting stands at 42.2%.
Why would the fed funds futures market dial back its rate-cut expectation when core rates of inflation are being dialed down?
Because the minutes for the March FOMC meeting indicated that the Fed has not closed the door on the possibility of a rate hike before the end of the year if economic activity improves, and risk factors dissipate, and because the weekly initial claims report showed the lowest level of initial claims (196,000) since 1969!
Initial claims are a leading indicator, and what this multi-decade low in initial claims suggests is that employers are reluctant to let go of employees, either because they can't find qualified workers or because they see demand being strong enough to justify the size of their existing work force.
The inference for the market is that the labor market is tight, which should lead (emphasis on the word should) to stronger wage growth in either case, because employers will have to pay more to find qualified workers or will have to raise wages of existing staff to keep them in place so as not to lose out on sales opportunities.
What It All Means
The stock market keyed off the line in the FOMC minutes that the majority of participants think the target range for the fed funds rate will remain unchanged for the remainder of the year. It also keyed off a dovish policy view from the European Central Bank (ECB), which said it stands ready to use all instruments at its disposal to help boost growth and inflation.
Pleasing comments from senior officials on trade negotiations with China; better-than-expected earnings from Delta Air Lines (DAL) and JPMorgan Chase (JPM); and better-than-expected export data out of China for March were some other catalysts that underpinned the stock market, which was headed for yet another winning week as of this writing.
The move in the fed funds futures market, though, flew below the radar.
The fed funds futures market isn't banking on the likelihood of the Fed raising rates anytime soon, but there was a minor, and peculiar, withdrawal of its rate cut expectations at a time when core rates of inflation moderated.
The stock market in the fourth quarter did not handle the idea of additional rate hikes very well, and if the economic data pick up -- and inflation rates pick up -- in a way that gets the Fed thinking seriously again about raising rates, the risk will build that the stock market sees some disinflation of its own in the form of reduced stock prices.