The Latest Inflation Data Is Out...

Wholesale inflation, or the Producer Price Index (PPI) came in hotter than expected today but lower than the previous month’s rate. September PPI was 0.5% m/m, down from 0.7% m/m in August but higher than the expected 0.3%. On a year-over-year basis, PPI was up 2.2%.

Core PPI, or PPI ex-food and energy, was also up more than expected, at 0.3% m/m vs. 0.2% expected. These may seem like small deviations, and they are in a vacuum, but the issue is still the “stickiness” of inflation, and how we seem to have entered a “chop zone” where inflation isn’t going down, but instead it’s chopping around in an elevated range.

Here’s the PPI plotted out over the last 2 years. The blue bars represent the actual, and the orange lines represent the expected values, so you can see where it came in hotter or cooler than expected. The highly elevated levels throughout 2021 and the first half of 2022 are fairly obvious to see, but what to make of the what’s happening lately? Throughout 2021, inflation was supposed to be “transitory”, with the Fed dropping usage of the descriptor in November of 2021, but how should it be described now?

PPI Month-over-Month

It’s too early to say if a new trend is forming, but it’s clear that price uncertainty is still very present, and with cold months approaching in the northern hemisphere and energy costs elevated globally, it’s going to be difficult to see a scenario where prices come down smoothly. Although we can strip out direct energy costs in metrics like Core PPI / Core CPI, higher energy costs still make everything else more expensive, so it’s never truly stripped out.

On Thursday (tomorrow) this week, CPI data will be released, which we’ll pair with the latest PPI readings.

The bond market is relevant again

For many millennial and gen-z investors out there, the bond market probably hasn’t been relevant in your investing lifetime. With rates artificially locked in near zero from 2008 to 2020, fixed income just has not been an attractive risk-reward proposition next to equities and other asset classes.

Here is the Fed Funds Rate since 2008. The Fed Funds rate is the effective rate that financial institutions lend to each other, and the Fed sets a target for it at each meeting, using different monetary tools including its discount/window rate to achieve this. It’s a critical benchmark for bonds and fixed income, because if banks are borrowing and lending from each other at higher (or lower) rates, then bonds being issued will be at higher (or lower) rates.

Now before you think, “well in 2019 it did increase to 2.4%”, take a look at the chart again, but zoomed out this time, showing rates back to 1955. Now you can see that the 2008-2020 period was a time with anomalously low rates. Also, the shaded grey areas indicate recession periods. You can also see that today’s “higher” interest rates really aren’t that high by historical standards.

Importantly – and this is not a coincidence – notice how rates increase leading up to recessionary periods, with maybe 1990 being an arguable exception. Then they fall back down during and immediately after recessions.

Given this backdrop, take note that bond market yields are retreating this week, with treasury yields falling the most since the bank panic earlier this year.

There are a few things happening in the bond markets right now:

·         Recent comments by some Fed Presidents that rate hikes may be nearing an end, which means investors would pile into bonds today to lock in higher interest rates, which drives up bond prices and lowers overall yields

·         Geopolitical uncertainty such as a war in the Middle East would produce a “flight to safety” effect where investors move more money into safer assets like treasuries, which would also drive up bond prices and drive down their yields

·         Investors that still believe a recession is impending will move money into longer duration bonds, hence the inverted/humped yield curve we analyzed in recent letters

As you can see, it is the bond market that is really controls overall investor sentiment, not the stock market. Money moving into stocks is more of a “downstream” effect, but the bond market represents the true pulse during times of volatility and uncertainty.

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