As measured by CPI, consumer price inflation was reported above expectations at a 5.4% year-over-year rate. The June inflation reading is the fastest pace since it reached 5.6% in July 2008. In addition, June retail sales were above estimates and bounced back from the May decline despite the hangover from the March stimulus-induced spending binge. This level of consumer spending supports a second-quarter U.S. GDP growth rate of over 7%. So why did the 10-year Treasury yield close lower for the week at less than 1.3%? This 10-year yield is down from greater than 1.7% in March.
The most significant piece of the puzzle is that some components of the inflation reading are abnormally high due to the low prices during Covid and supply chain disruptions. These conditions are almost sure to pass as supply, and year-over-year comparisons normalize. For example, car rental and used car prices were 88% and 45% higher year-over-year, respectively. It seems likely that June will be the peak year-over-year rate.
Removing the distortions in the year-over-year numbers due to low prices during the Covid lockdowns still leaves CPI running at a 3.3% annualized rate and commodity prices rising at an 11% annualized rate since December 2019. The Atlanta Federal Reserve measure of Sticky CPI, which attempts to remove the noise and measure structural inflation pressures, was 2.7% higher year-over-year in June. Other Federal Reserve banks have alternate measures to accomplish the same objective. They are all higher with the New York Fed’s estimate of underlying inflation at almost 3.5% year-over-year.
Some portion of this higher underlying inflation should moderate as supply chains return to normal. In addition, technology is inherently disinflationary. Lastly, there has been a massive increase in productivity when one considers that the economic output of the U.S. is almost sure to hit a new high when the second-quarter data is reported. At the same time, nearly seven million fewer people are employed. Setting aside the human toll on the unemployed, if this higher level of productivity remains durable, it will provide a disinflationary impulse.
Markets do seem to believe that the Federal Reserve will tighten monetary policy sufficiently to avoid runaway inflation. In fact, economic growth expectations seem to be laboring under concerns that the Federal Reserve could remove stimulus too quickly and smother growth. The yield curve, which has accurately predicted most recessions when the yield on the 10-year Treasury has fallen below the 2-year, reflects these misgivings. The difference in these yields was as high as 1.6% at the end of March but has narrowed to less than 1.1%. While the yield curve is still far from signaling recession, it is flashing a possible warning sign for future woes. In addition, there are some worries that the Covid variants could lead to another lockdown, so there is likely demand from those seeking the safety of U.S. Treasuries.
The global economic calendar is relatively sparse this week, and the Federal Reserve is in a quiet period, so the second-quarter earnings season should take on additional importance. According to FactSet, 79 S&P 500 companies are scheduled to report earnings. While the banks dominated the earnings releases last week, the upcoming reports should provide a more broad-based look across various industries. S&P 500 earnings are slated to grow at over 63% year-over-year. If results so far are any guide, actual earnings should still handily exceed these elevated forecasted levels. While it will be necessary for earnings and sales to beat expectations, forward guidance will be essential with the current worries about the economic outlook. Lastly, the effect of higher costs and the ability to pass on higher prices to protect profit margins will be closely scrutinized.
Aside from earnings, the U.S. economic calendar has several June housing data that should cause no concern regarding the health of this segment of the economy. July Markit PMI data on Friday should continue to reflect economic growth in the U.S., U.K., and the Eurozone. The services component of the PMI reports will be of particular interest as they could indicate some pressure on in-person services due to increased infections from the Delta variant. The European Central Bank meets on Thursday with no chance of a change in monetary policy rates, and any announcement of a reduction in the pace of asset purchases is not yet likely on the menu.
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