Another Horrible Inflation Report - Why Is The Bond Market Ignoring It? (US10Y) (2024)

February CPI report

The US BLS reported the CPI inflation report for February, and it shows that CPI inflation continues to be elevated and sticky at a level well above the Fed's 2% target.

On an annual basis, the core CPI dropped to 3.8% in February from 3.9% in January due to the base effects. But, the monthly core CPI inflation increased by 0.4% in February, which matches the 0.4% increase in January - a 0.4% monthly inflation is consistent with the 4.5%-5% annual inflation rate.

So, are we heading towards the 5% core CPI inflation level? Are we just starting the second wave of inflation? The answer is - it is very likely.

The monthly core CPI has been accelerating since June 2023 when the print was 0.1%, and now we have two months in a row with the print of 0.4%.

By looking at the base effects, if the March core CPI also comes at 0.4%, the disinflationary process on annual basis is over, the core CPI will increase on annual basis.

But the consistent increase in the core CPI will start in June of 2024 - this is when the base effects will fade out, or when the April/May 2023 will be deleted from the count. This will be the time when the core CPI starts rising from the 4% level towards 5%, as low inflationary readings from summer of 2023 are replaced with the (likely) higher prints.

What's pushing inflation higher?

The Fed's needs to see monthly inflation at 0.1%-0.2% to get to the annual 2% inflation target. But we are now getting 0.4% prints, and it's very possible we will start getting 0.5% prints by looking at what's driving inflation higher.

Also, let's also look at the all-items CPI inflation, which also increased by 0.4% Mom in February, and actually increased to 3.2% in February from 3.1% in January on an annual basis, after being stalled at the 3% level since June 2023.

Gas prices are rising. Energy prices increased by 2.3% MoM in February, led by 3.6% MoM increase in gas prices. This trend could continue and push energy prices much higher, given the geopolitical situation.

But it's not just the geopolitical situation that could keep boosting energy prices - the Fed actually is a bigger risk. Specifically, the Fed wants to cut interest rates, possibly due to the political pressure in an election year - despite the obviously rising inflation.

If the Fed actually follows up with the interest rate cuts in an inflationary environment, the US Dollar could significantly weaken, which could push the oil price (USO) much higher (as well as the prices of other commodities).

This is what actually happened in 2008. The Fed was starting to cut interest rates in early 2008 because the economy was entering a recession, which caused the USD to weaken and pushed the price oil from $100/barrel to $150/barrel.

Yes, during that time in 2008, China was also growing at a very high rate, and now it is barrel hitting a 5% growth. But China is trying to stimulate its economy, which could increase the oil demand over the near term.

So, this is the major risk for the inflation going forward - dovish Fed, weakening USD, escalating geopolitical situation, and attempts to boost the Chinese economy. The combination of these effects could start the second wave of inflation, with the 0.5%-0/6% monthly prints.

Shelter inflation continues to be a problem. Shelter inflation increased by 0.4% in February, down from 0.6% in January. But the rent part of the shelter increased by 0.5% in February, more than 0.4% in January. The OER (Owners' Equivalent Rent) part of the shelter increased by 0.4% in February, down from 0.6% in January.

But here is the problem, BLS increased the weight in OER this year relative to rents. So, in January the spike in OER caused the spike in shelter. Now the rents are spiking and OER is moderating - and this is causing shelter to moderate. This is unsustainable.

The OER is correlated with the housing prices, and if the Fed lowers the rates, and mortgage rates decrease as well, it is likely that the housing bubble will continue to inflate. Yes, there is a housing bubble based on price-to-rent ratio. So, this is the second channel via which the Fed could cause the second wave of inflation - reinflating the housing bubble and thus boosting the shelter inflation.

So, it's all about the Fed

The current inflationary spike (in January and February) follows the surprise Fed's dovish turn in December. The Fed signaled that it plans to cut interest rates three times in 2024, and the market views this as a preventive easing policy due to possible political pressure in an election year.

Thus, the financial conditions loosened significantly - the interest rates decreased, the USD weakened, and the stock market soared. But this is now also reflected in the 0.4% monthly inflation readings.

And, as I explained in this article, if the Fed really follows up with the cuts, it could get worse - the USD could significantly weaken, oil could spike, the housing bubble could reinflate, and all of this will be reflected in rising inflation - the second wave.

Implications - the bond market is ignoring the reality

We know that the stock market can be irrational. The stock market (SP500) is still pricing the GenAI theme, and instead of selling off due to the hot February inflation data, it rising due to Oracle (ORCL) earnings and possible partnership with Nvidia (NVDA), which is also push NVDA and other AI stocks higher, and thus the Nasdaq 100 index (QQQ) higher.

But the bond market reaction is mysterious. The 2Y yields (US2Y) (SHY) are just marginally higher, while the December Federal Funds futures are still pricing three cuts in 2024, with the first cut expected in July - this will be the exact time when the core CPI starts rising. Plus, the expected cuts are leading to the November election. Both of these make no sense.

Thus, shorting SOFR futures expiring in 2024 seems like a good trade.

The 10Y yields (US10Y) (TLT) are also rising marginally, still pricing the long-term inflation expectations anchored at 2%. If the Fed is allowing inflation to stay at 3%, then 10Y yields should be well above 5%.

The key implication is that the bond market can't stay irrational for much longer - either we will soon see a major weakening in the economy, or the interest rates will have to increase, with the 10Y yields rising towards 5%.

Damir Tokic