The start of the second quarter has been quiet in the fixed income market, with the yield curve unchanged and a dearth of new issuance.
The March inflation measures, which was expected to be elevated, didn’t disappoint. The Producer Price Index, released Friday morning April 9th after a computer glitch at the BLS held up the report for 25 minutes, registered 4.2% YOY. Well above last month’s 2.8% reading. Traders chose to ignore the surprise though, and the bond was little changed on the day.
The second inflation gauge, The Consumer Price Index, released on Tuesday April 13th, also came in above expectations. Forecasters had been looking for 2.5% YOY, up from 1.7% the prior month. The actual number came in 0.1% higher than expected at 2.6% YOY.
The Fed has repeatedly said they intend to look past any transitory inflation, so it wasn’t surprising to see traders ignore the recent reports. Indeed, the Fed has pointed to the base effect of last year’s depressed index versus the uptick in economic activity this year. Their belief is that once economic activity levels off, so too will the change in goods prices. The flaw in their thinking, in our opinion, is that despite high unemployment, employers are complaining of a lack of qualified workers to fill much needed job openings. As a result, those employers are being forced to raise wages to attract talent. Compounding the demand-driven compensation inflation, the populist argument for a fair living wage and $15 minimum wage seems to have skewed potential employees to demand higher wage in all sectors of the economy. This thinking is likely to keep the unemployment rate high and prolong the wage inflation cycle.
Also threatening the Fed’s transitory view is the recent acceleration in home prices. The demand for housing is coming from three divergent sources. The first is city dwellers fleeing the apartments that many have been sequestered in since last year in favor of the fresh air and accessibility of the suburbs. With the COVID vaccine enabling those living in the city to browse houses for sale, they have been actively snapping up the limited supply available.
Competing with those buyers are institutional funds that are buying homes as the cap rate of owning and renting exceeds anything that can be found in the Fixed Income market, including sub-investment grade credit.
The third source of demand are residents in high tax states saying “enough is enough” and fleeing to lower tax locales. With the massive spending packages and the soon to be rising taxes it’s hard to argue with that logic.
However, with demand exceeding the supply of existing and newly constructed homes, the forecast is that the home price inflation is not likely to be transitory.
Given the dynamics in the economy as it gears up from its yearlong slumber, the Fed may find it difficult to justify the current ultra-easy money policy for as long as they have indicated that will continue.
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