Surprising Inflation Numbers

WEEK ENDING 3/15/2024

A CITY DIFFERENT TAKE

Core inflation in February turned out to be higher than expected. Headline CPI surprised to the upside by 0.4% with core index (not including food and energy) also rising 0.4%. The “supercore” CPI measure (core services excluding tenants’ rent and owners’ equivalent rent), came down to 0.5% in February from 0.8% a month ago. These numbers show that inflation is anything but linear. Core CPI is at 3.8% year-over year.

Headline PPI also trended to the upside. Headline PPI doubled expectations, rising by 0.6% in February. The jump came from higher gas prices. Year-over-year headline PPI is just under 2%, but core is at 2.75%.

Fixed income markets responded to higher inflation numbers with a jump in yield of 15 to 20 basis points across the curve.

Both the CPI and the PPI reports are very meaningful numbers for the Federal Reserve, which meets this week. And this will not be a boring meeting. Sticky inflation and strong economic growth will make things interesting. Plus, back-to-back increases in inflation this year (for the months of January and February) will strengthen the Federal Reserve’s conviction of a higher-for-longer pause before a rate cut. (Every Fed participant has hinted at leaving rates unchanged for now.)

We will also get a refreshed dot plot out of this meeting, as well as an update on quantitative tapering. We’ll also be watching the Fed for their summary of economic projections — the Fed’s take on the economy. This includes GDP growth forecasts, unemployment estimates, and PCE and core inflation forecasts.

Currently, the market is predicting an 85-basis-point rate cut for 2024, starting in June. The Fed dot plot suggests three 25-basis-point cuts with equal distribution for this year. The Fed’s dot plot and market expectations are coming closer to alignment than they were in December of 2023.

CHANGES IN RATES

Treasury rates moved up significantly across all tenors and continue to build upon rates that have risen from last week.

At CDI, we ran some mathematical scenarios of solely yield basis calculating. So, what’s a better buy — a three-year Treasury bill or a money market fund?

Assuming T 4.25 3/15/2027 yielding 4.36% on a three-year Treasury bond and 3 Month Tbill as a Proxy for money market  yielding 5.25%  here are our conclusions:

1. Our math indicates that if it takes two years for real rates to come back to the historical average, then you break even. It doesn’t make a difference which one you own.
2. However, if rates break even in less than two years, then you win by holding a three-year Treasury bill over a money market fund.
3. Conversely, if rates do not break even in less than two years, then the money market fund wins over the three-year Treasury bill.

Rates rose on the shorter part of the curve.

The municipal/Treasury ratio got more expensive in the 1–10-year part of the curve. Ratios are rich relative to Treasury and also to U.S. corporates.

Rates in the corporate market segment followed the Treasury market and rose significantly.

THIS WEEK IN WASHINGTON

Russia’s election results showed Putin winning 87% of the votes, extending his term as president by another six years. This also makes Putin the longest-serving president in the country’s history. While the outcome of the election is not surprising, it is worth acknowledging the inevitable extension of Putin’s war in Ukraine. 

Last week, we talked about the bipartisan support for TikTok legislation, essentially banning it across the country. This will be an interesting and long road with several litigation leading to decisions between national security and free speech. 

Former President Donald Trump made some notable threats and suggestions on the campaign trail. Trump threatened 100% tariffs on cars made in Mexico by Chinese companies. He later suggested he would replace the Federal Reserve chair if elected president.

Meanwhile, President Biden’s reelection campaign is well underway with a massive war chest. According to the media, Biden sits on $155 million — the highest campaign fund total of any Democratic candidate in history.

WHAT, ME WORRY ABOUT INFLATION?

The 5-year Breakeven Inflation Rate finished the week of March 15 at 2.25%, nine basis points lower than the March 8 close of 2.34%. The 10-year rate finished the week at 2.32%, four basis points higher than the close of March 8 at 2.28%.

MUNICIPAL CREDIT

10-year quality spreads (AAA vs. BBB) as of March 15 were 1.20%, one basis point wider than the March 8 reading of 1.19% (based on our calculations). The long-term average is 1.71%.

At 0.69%, quality spreads in the taxable market last week were one basis points tighter than the week before. High-yield quality spreads on March 15 were at 2.64% versus 2.93% last week.

WHERE ARE FIXED-INCOME INVESTORS PUTTING THEIR CASH?

Money Market Flows (millions of dollars)

Money market funds saw higher flows in both tax-exempt and government categories, while prime saw a slight drop.

Mutual Fund Flows (millions of dollars)

The municipal market received a big inflow last week.

ETF Fund Flows (millions of dollars)

ETFs saw a big uptick in weekly issuance across all categories.

SUPPLY OF NEW ISSUE MUNICIPAL BONDS

Year-to-date municipal supply has been robust. But so has demand, with close to $21 billion worth of coupon reinvestment coming up in March/April. This week’s municipal tax-exempt supply is projected to be close to $6.3 billion.

CONCLUSION

This is an important week. The Fed is not expected to raise rates. They are, however, expected to provide guidance for its dot plot and quantitative tightening after last week’s hotter-than-expected inflation prints for both CPI and PPI data.

IMPORTANT DISCLOSURES
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