Further Gains In Bonds Will Be Tough To Come By

With last week’s encouraging Consumer Price Index (CPI) reading of -0.1% for June, the bond market caught a fresh bid that took Treasury yields lower across the entire curve.

The two-10 spread is now -0.27%. While still inverted, the yield curve is flattening out with the Fed not even having started to cut rates.

Bond prices are near four-month highs, despite a hotter Producer Price Index (PPI) report for June. Final demand increased 0.2% month over month in June (consensus 0.1%) following a revised no change in May (from -0.2%). The index for final demand, less food and energy (core PPI), was up 0.4% month over month (consensus 0.1%) after a revised 0.3% increase (from 0.0%) in May.

On a year-over-year basis, the index for final demand was up 2.6% versus 2.2% in May, and the index for final demand, less food and energy, was up 3.0%, versus 2.3% in May. The key takeaway from the report is that the year-over-year rate for PPI and core PPI accelerated for the fifth month out of the last six with rising prices of services outweighing falling prices of goods in June.

Assuming the economy grows at its current projected pace of 2.0% per the latest Atlanta Fed GDPNow release, this very sticky and inflationary “services” component to Core PPI looks like it might be tough to bring down much further. For June, prices for every line item within the services table, apart from transportation and warehousing services (-0.4%), truck transportation freight (-1.2%), loan services (-2.0%) and traveler accommodation services (-0.2%), were higher month over month.

Even though inflationary expectations have dipped recently, the lower Consumer Sentiment Reading of 66.0 for July released last Friday shows that consumers remain burdened by high prices. If the PPI stays higher for longer, it can indirectly impact CPI by affecting production costs and supply chains that ultimately get passed on to the consumer.

Source: www.bls.gov

Hence, one can argue that if both PPI and CPI are not moving down in tandem with each other, then the Fed’s 2% target looks like a stretch without the economy sliding into a mild recession or something worse. So many of the goods and services we use related to the upkeep of our health, homes, cars, education, childcare, public transportation, insurance, legal, accounting and other white-collar services are priced at levels that are at all-time highs with little, if any, relief in sight.

Assuming this is the big picture for most families and individuals, then we should all feel fortunate that inflation is sitting at 3%, and down from 9% two years ago. I think this is about as good as it’s going to get on the inflation front, again barring a sharp economic contraction of sorts. This implies that the yield curve may normalize where long-term rates finally get above short-term rates, but probably not by much unless the market loses faith in the Treasury’s ability to manage the current $34.9 trillion in federal debt, where longer-term rates would likely spike.

At some point, federal revenues need to exceed government spending. Depending on the source, the U.S. national debt will exceed $40 trillion in four years to put debt-to-GDP at 130-160% from its current level of 122%. It got up to 132% during the pandemic, pulled back and is again resuming its upside trend. This assumes U.S. GDP will grow to $32 trillion from $25 trillion by 2028.

It is exactly during these times of economic expansion that the government should be paying down its debt in the event of another economic shock. However, both the bond and stock markets have been functioning well with the ever-growing mountain of debt as the S&P 500 cleared 5,600 for the first time in history last week.

Lower Treasury yields also tend to weigh on the underlying dollar currency since they aren’t paying out as much. The dollar index has fallen 2% this month in reaction to the notion of lower interest rates on the horizon. So, it stands to reason that seeing the yield curve flatten out at 4% and staying there to keep the dollar stable while maintaining a sustainable appetite for soaring U.S. debt offerings to global buyers makes sense. To summarize, it would seem that Goldilocks would be quite happy with 2% GDP growth, 3% inflation and 4% interest rates.

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