Halyard’s Weekly Wrap – 3/15/24 – Bracketology vexes US Treasury Market – Yields rise.

The bullish tone on which the bond market closed last week has completely reversed and is closing this week with a decidedly bearish resolve.  The hope had been that the inflation measures this week would show further progress toward the Fed’s 2% target.  That didn’t happen.  Instead, the Consumer and Producer price indices both moved higher on a month-over-month basis in February.  The core CPI index was 0.4% higher than the January measure, rounding to roughly 5.0%, a far cry from the Fed’s target.

On the other hand, retail sales for February disappointed as the actual month-over-month change came in at 0.6% versus the 0.8% expected and the January outcome was revised 0.3% lower.  The lower-than-expected sales were not nearly enough to offset bond selling as investors have become concerned that inflation is reemerging.  Exacerbating that concern was Treasury Secretary Yellen’s comments on Wednesday that the inflation trend was favorable, but she doesn’t expect a “smooth path” lower.  Reading between the lines, we wonder if that means that we should expect inflation to annualize at 3.8% for the foreseeable future?  That’s an important question for several reasons.  First, the yield curve is inverted.  The yield curve becomes inverted when investors expect that rates will be falling in the future.  If inflation becomes imbedded at the current level, interest rates will not be falling anytime soon.  Secondly, historically the 10-year treasury note trades about 150 to 200 basis points above inflation, which means that the current 10-year is mispriced.  Plugging the 10-year into the Bloomberg price calculator assuming 3.8% inflation indicates, using the historical rule of thumb, that the 10-year is approximately 7.5% too expensive.  That’s an enormous overvaluation!

All eyes will be on the outcome of the FOMC next Wednesday.  The Fed is not expected to make a change to the overnight rate, but the economic projections of the various members will generate close scrutiny.  Those “dot plots” upended the market in December when it showed the expectation of three rate cuts this year and the hint that the first rate cut would be at the March meeting.  At the time, the conventional wisdom was that the rate hikes to date were at risk of pushing the economy into a recession and the cuts would be needed to stimulate the economy as it faltered.  Through the first 10 weeks of 2024, only pockets of economic weakness have been observed while employment remains strong and inflation stubborn.  We suspect that three rate cuts will continue to be the consensus but wouldn’t be surprised to see several of the forecast’s drifting higher.  Especially since five members forecast that rates could be cut by more than 75 basis points this year.