CPI slightly hotter than expected

Earlier this week we said it’s a big week for inflation and prices, and we looked at the Wednesday PPI which came in hotter than expected. Yesterday, the CPI also came in hotter than expected, slightly, at 3.7% vs. 3.6%. Now, that 0.1% may not sound like a lot, but remember, this measure is 3.7% higher than October 2022, which was 8.2% higher than October 2021, which was 5.4% higher than October 2020. So these increases are compounding the longer that inflation stays around. This is the danger of persistent, sticky inflation – price increases now are all on top of prior year price increases.

Here is the CPI over the last 10 years. Similarly to PPI, it’s come down, but the most recent readings also show that it’s not coming down consistently and in a straight line, with a bump back up over the last few months.

And although 3.7% seems far improved from the highs of 9.1%, it’s still 85% higher than the Fed long term target of 2.0%.

The market reaction was negative, but all things considered, fairly muted. Perhaps investors thought inflation data was “close enough”, or maybe the focus was elsewhere like instability in the Middle East, or maybe the market is reaching complacency with regard to the data and waiting for some other economic shoe to drop, like the labor or credit markets.

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Bond auction moves the markets

What really moved the markets this week was the bond auction yesterday. As we said earlier in the week – watch the bond markets. Even if you’re not a “bond person”, start watching them and over time you’ll become more familiar.

The US government regularly issues bonds to finance its perpetual budget deficits, pay interest on outstanding debt, and other things. In normal times, this is a boring and unremarkable process, as government bonds are issued of various maturities, institutions and other governments scoop them up because they need safe places to park their money, and that’s it. We’ve grown accustomed to an infinite global demand for US debt, so that’s how the US has been running its fiscal situation. For a long time, the US economy was growing at such a pace where the debt situation didn’t really matter, because the expectation was that the economy would simply grow over time, we’d make more “stuff” next year, and use that increased production to pay our interest on debt.

Now, with growth projections for the next few years slowing rapidly, but government debt still ever-increasing, more and more economists are pointing out that this is an unsustainable trajectory, with a recent report saying that interest on debt will be the single biggest expense of the government by 2050. Bigger than social security expense.

And as a sign that we cannot simply issue more debt in perpetuity, yesterday at the 30-year bond auction for treasuries, demand was far weaker than expected, prompting yields to go up, and making more people aware that it is not a guarantee that the US can simply issue as much debt as it wants or needs at any time. For traders, this was the significant market drop seen at 1pm yesterday, and supports our comments earlier that the bond markets will drive the equity markets in this current environment, not the other way around. Because remember, US treasuries provide the risk free rate, which other assets like stocks are priced on. If treasury yields go up, which they will if demand is weak, then the cost of financing across the board goes up, driving down asset prices like stock prices, since US-based companies (including global companies that use the US capital markets for capital) will now have to pay more to finance their operations.  

Government bond auctions are extremely esoteric stuff, but for those interested, here’s what the release looks like and why the market responded. $20bn of 30-yr bonds were issued, with 18% of them needing to be bought up by dealer banks, “unwanted” by investors (circled number in screenshot). With low demand, those bonds were bid lower aka yielding higher. As an aside, dealer banks are obligated to take bonds at auction as part of their role as a dealer bank, that’s how our Federal banking system works.

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