Stubborn Inflation

WEEK ENDING 4/26/2024

• Real GDP growth slower than expected at 1.6% for Q1.
• Core PCE for the year is unchanged at 2.8%.
• Market pushes the probability of rate cuts (if any) to the end of the year.

A CITY DIFFERENT TAKE

Last week solidified the understanding that inflation is here to stay. Markets had to contend with slower GDP data and hotter-than-expected inflation numbers.

Real GDP increased at 1.6%. This was a lower-than-expected number driven down by trade and inventories. Consumer momentum, however, was strong, and real spending increased by 0.5% in March. Remember, the job market is still strong, with the unemployment rate at 3.8%. We would argue that the domestic economy is still solid, with a tight labor market and decent domestic spending (which rose to 2.8% this quarter).

The Atlanta Fed is forecasting second-quarter GDP growth at 3.9%. The low first-quarter growth was disappointing because it followed 3.4% growth in the prior quarter and an average increase of 4.2% from the second half of 2023.

Core PCE jumped to 3.7% in Q1. The upward surprise was due partly to upward revisions to January and February data. Supercore — core PCE excluding housing — followed the same trends as core PCE, which means strong surges in prices in January and modest increases in February and March. YoY core PCE stands at 2.8%.

The Federal Reserve is wedded to a 2% inflation target. Three straight months of inflation increases show that data is not pointing in the Fed's expected direction.

The double whammy of slow growth and sticky inflation supports the higher-for-longer rates. We will probably see Chair Powell peppered with questions about stagflation again.

How does the market digest all this data? At the start of the year, we had six cuts penciled in for 2024. By March, this dwindled to three, and after last week, we are looking at a consensus of one or two rate cuts around the end of the year. The market is hearing the message that growth is slowing, and inflation is here to stay — reacting Thursday with 10-year Treasuries jumping to 4.75%.

We will learn more about the Fed’s thinking this Wednesday at the FOMC meeting, but we expect to see a more hawkish Fed. No one is expecting a rate cut. The question is now not around “how many” rate cuts for 2024 — instead, if there are any rate cuts in the cards for 2024.

CHANGES IN RATES

Treasury rates moved higher on the week. The yield rally peaked last Thursday with the GDP release but dampened on Friday with a net small yield increase for Treasuries.

The municipal market’s yields moved higher on the week.

Municipal/Treasury ratios increased across the board, as Munis got less expensive.

Last week, the longer end of the credit market rallied in yield.

THIS WEEK IN WASHINGTON

Last week’s GDP and inflation data will dampen President Biden’s campaign message of a strong U.S. economy.

College students nationwide are protesting and demanding schools divest capital from companies in the war and defense sectors, which experts argue is not that simple. Protests are wide-ranging from the University of Southern California to Columbia University, and officials are looking to dispel crowds before graduation ceremonies.

On the global stage, Secretary of State Antony Blinken visited China and met with President Xi Jinping and senior Chinese officials. AP News reported how Blinken stressed that “even as we seek to deepen cooperation, where our interests align, the United States is very clear-eyed about the challenges posed by (China) and about our competing visions for the future. America will always defend our core interests and values.” The top issues discussed included China’s support for Russia’s war in Ukraine, Taiwan, and the South China Sea and human rights. They also addressed China’s role in preventing further escalation in the Middle East, where he will land today with the hope of securing peace in Gaza.

WHAT, ME WORRY ABOUT INFLATION?

The 5-year Breakeven Inflation Rate finished the week of April 26 at 2.44%, three basis points higher than the April 19 close of 2.41%. The 10-year Breakeven Inflation Rate finished the week at 2.43%, two basis points higher than the close of April 19.

MUNICIPAL CREDIT

10-year quality spreads (AAA vs. BBB) as of April 26 were 1.14%, five basis points lower than the April 19 reading of 1.19% (based on our calculations). The long-term average is 1.70%.

Quality spreads in the taxable market are not attractive and ended the week lower at 0.67%. High-yield quality spreads were 2.87%, 15 basis points lower than April 19.

WHERE ARE FIXED-INCOME INVESTORS PUTTING THEIR CASH?

Money Market Flows (millions of dollars)

Money market funds saw a big influx in cash flow with growth in all three categories.

Mutual Fund Flows (millions of dollars)

Bond funds saw decreased cash flows with the exception of government.

ETF Fund Flows (millions of dollars)

All ETF asset classes saw outflows.

SUPPLY OF NEW ISSUE MUNICIPAL BONDS

After a bonanza calendar of last week, tax-exempt supply projections have dropped this week to $5.8 billion.

CONCLUSION

The rates market showed a yield rally after a slowdown in GDP and stubborn data releases from last week. The Federal Reserve meets this week. We strongly suspect they will reiterate a hawkish message of “higher for longer.” The conversation on rate cuts has turned away from how many cuts this year to whether there will be any cuts at all.

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