The hottest U.S. consumer inflation reading in almost 40 years is bringing a surprising sigh of relief in certain corners of the financial markets, where some were expecting a headline year-over-year number closer to 7%.
The relief was evident in investors’ appetite for U.S. Treasuries Friday morning after the government’s consumer price index report, which showed the headline year-on-year reading at 6.8% for November. While undoubtedly high, the reading dodged the 7% level that a few saw as a risk, raising hope that inflation may be in the process of topping out.
While the CPI print was high, “some folks on Wall Street were expecting an even higher number” and the core CPI number, which excludes volatile items, “was in line with expectations,” said Tim Holland, chief investment officer of Orion Advisor Solutions.
“The two points above have many thinking that we are close to, if not at, peak inflation,” Holland wrote in an e-mail to MarketWatch. “That strikes us as a reasonable view, which would point us towards lower inflation going forward, which would support / justify little to no movement in yields.”
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For the average investor, the difference between 6.8% or 7% might seem like a simple rounding issue. But for economists and traders with money on the line, inflation has proven to be stronger and more durable than anticipated this year, and Friday’s reading carried a risk of another overshoot that couldn’t be ignored.
Fixed income tends to be the asset class that gets hit hardest by rising inflation, which erodes the fixed value of bonds. Ordinarily, investors would be selling off Treasuries in response to a higher inflation print, which would lead to higher yields. Instead, ongoing demand for U.S. government debt, whether domestically or from abroad, pushed bond prices higher and yields lower Friday morning, as investors turned their attention to next Wednesday’s policy update from the Federal Reserve.
Yields fell across much of the curve Friday before turning mixed in afternoon trade. The 10-year yield TMUBMUSD10Y, 1.487% rose to around 1.49%, while the 30-year TMUBMUSD30Y, 1.882% climbed to roughly 1.9%, though both remain near historically low levels.
Surprisingly, the 2-year yield, which reflects expectations for the near-term path of Fed policy, fell to around 0.66%, which is still not far from the highest levels of the year. The move is counterintuitive because investors are expecting the Fed to proceed with a faster pace of tapering bond purchases, in order to have greater flexibility to hike interest rates sooner next year and combat inflation.
Meanwhile, equity investors seemingly brushed off the inflation print, with all three U.S. stock benchmark indexes climbing Friday afternoon.
Gennadiy Goldberg, a senior US rates strategist for TD Securities, says the market pays less attention to the headline year-on-year figure than it does to the monthly numbers. “Yields are declining because month-over-month inflation didn’t come in as high as expected, and a lot of Fed tightening has already been priced in — with almost three rate hikes expected for 2022,” Goldberg said via phone.
“If you look at the long end and the pricing for rates in overnight-indexed swaps, the long-run terminal rate is just 1.5%,” below the 2.5% seen by Fed officials in September, he said. “That’s an indication that the market could be penciling in some policy error.”
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