An inversion supercharged by repositioning and confusion as much as economic concerns

The U.S. Treasury curve gyrated last week after the release of June’s hot CPI.  Short-term rates surged while longer-term rates fell as the market repriced for the possibility of more aggressive Fed rate hikes and a weaker U.S. economy.  The week ended with 3-month T-bill rates up 40 bps, the biggest move by maturity as the front end repriced further to a summer of Fed tightening.  The 2-yr yield rose just 1.5 bps last week while the 10-yr yield fell 16.5 bps. We now have notable inversion with the 2-yr exceeding the 10-yr yield by ~ 20 bps.  That inversion was even deeper after Wednesday’s CPI report.  Rates past 10 years fell the most last week, aided by a strong 30-yr bond auction on Wednesday.

Credit markets are looking ahead defensively

As the intensifying spike in rates puts a greater focus on the potential for recession, concerns over corporate credit quality have grown.  Non-investment grade credit spreads have been widening since the Fed’s inflation pivot last November from very tight levels that benefitted borrowers.  By mid-June, spreads had widened to levels that were less skewed to the issuance side.  Following the May CPI print, spreads have widened further.  This past week, some notable Q2 bank earnings were adversely impacted by increases in loan loss reserves as banks look ahead to a more challenging operating environment.

The CLO market, structured with leveraged loans (non-investment grade), has been recently hampered by concerns over potential downgrades and defaults. This important funding mechanism serves as a critical source of liquidity for many borrowers and non-bank lenders.  At this juncture, credit concerns far outpace actual defaults and downgrades, but deal flow has slowed as investors get increasingly defensive. The potential danger here is if the CLO market cannot function amid defensive posturing by investors, it could create its own adverse destiny for borrowers if liquidity dries up.  While by no means at crisis levels, this market should be watched closely, and we will update as conditions change.

Dollar’s continued strengthening sets the stage for eventual instability

With the Fed acting and talking aggressively against the hottest inflation in over 40 years, the interest rate differentials between the U.S. and both the eurozone and Japan continue to be monumental.  3-month Term SOFR (CME) increased 31 bps last week to 2.55%, up 50 bps just since June 28^th.  While rates have moved up in the eurozone recently and barely in Japan, they remain near rock bottom.  Three month rates in the eurozone (Euribor) and in Japan (ICE Yen Libor) ended Friday at just 7 bps and -1.5 bps respectively.  The rate differential clearly favors the U.S. dollar (USD) and speaks to how forceful capital flows have shifted in favor of USD. Last week, the euro reached parity against the U.S. dollar for the first time in 20 years and the Japanese yen briefly fell to JPY 139 intraday, a 24-year low against the USD.

Why this matters for U.S. interest rates: The USD’s rise has been mostly one way and that can lead to eventual instability. The volatility is likely to come from both eventual policy tightening by the ECB and maybe even the BoJ after the Fed has moved through most of its tightening by yearend.  The enormous currency market can move with lightning speed so there’s potential for serious volatility.

Furthermore, since the beginning of this year, total foreign demand for U.S. Treasuries (USTs) have fallen noticeably, in both absolute and percentage terms of outstanding debt.  Changes in interest rate differentials, USD strength, and currency risk have played a part.  Japan’s holdings alone (the largest foreign holder of USTs) have dropped $85 billion so far this year (thru April) to $1.22 trillion.  The Treasury will report on May’s holdings today, July 18^th.

Last week’s data highlights

Inflation sizzles, exceeding expectations for a fourth straight month

June’s U.S. CPI outcome was unsettling as it showed inflation accelerating further despite 150 bps of cumulative Fed rate increases.  The headline CPI climbed 9.1% YoY last month for the largest increase since 1981.  Core prices, excluding the effects of food and energy, rose 5.9% from a year earlier in June and were down fractionally from 6.0% in May.

A monthly rise of 1.3% in June’s headline CPI was the most so far in this post covid inflation environment, setting off alarms, up from 1.0% in May and 0.3% in April.  Upward price pressures were broad and the monthly core CPI rose 0.7% last month, up from 0.6% in May, the most this year.  Price increases for gasoline, food, and shelter were the largest contributors.  The energy index alone rose 7.5% over the month contributing to almost half the headline increase with gasoline up 11.2%.

Gasoline to the rescue?

Retail gasoline prices fell an additional 15 cents last week to $4.55/gal, down 47 cents from the June 13 peak of $5.02.  Prices averaged $4.93/gal last month and $4.70/gal this month so far … if this decline holds (or intensifies) through the end of July, next month’s CPI release should soften.  For interest rates, any signs of moderating inflation pressures will potentially ease rate hike expectations and curb volatility.

Less purchasing power in June

Due to inflation, real average hourly earnings fell 1% MoM in June, down 3.6% YoY and real average weekly earnings were down 1% MoM in June, equating to a decline of $17.22 from a year earlier to $374.76.  Inflation continues to eat up wage gains.

Wholesale prices were also hot in June but import prices show some moderation

The U.S. Producer Price Index (PPI) rose 11.3% YoY last month and 1.1% for June, exceeding consensus expectations.  Energy prices were a big component of the June advance.  The core PPI, ex-food and energy, rose 0.4% MoM and 8.2% YoY, the least since Nov.  This may finally be peaking as moderating prices have been visible in food, crude oil and raw materials.  Earlier stage of production price pressures for goods and services (not final out the door prices) have already peaked.  Import prices increased a less than expected 0.2% MoM in June while compared to a year ago rose 10.7%.  The annual core figure, excluding food and energy, rose 4.4%.

Sentiment measures are still weak

The NFIB index of U.S. small business optimism, fell in June to its lowest since Jan 2013 while falling below the covid low of April 2020 (then reached in freefall).  The index has been in decline all year amid rising inflation and labor shortages.  U. of Michigan’s preliminary consumer sentiment index rose slightly in July, after Q2’s decline, for the first rise since April.  While the index remains close to its lowest level ever (June), it shows that lower gasoline prices can help improve the overall mood.  The long-term inflation expectations component of the index fell to a one year low of 2.8% from 3.1% in June, a calming data point for the Fed and the bond market.

Job market is cooling in slow motion but there’s still plenty of slack

Weekly Jobless claims for unemployment insurance rose to 244k, the highest since Nov, exceeding expectations.  The more trending 4-week moving avg rose to 235.8k, highest since early December.  Claims are on the rise; the average for 2021 was 222.2k. Higher claims typically appear before unemployment rises and therefore, more attention should be paid to this high-frequency data point (every Thursday).  If the U.S. unemployment rate were to start rising, it would influence the Fed’s rate tightening agenda.

Retail sales rose amid higher prices but spending fell in “real” terms

Retail sales rose 1% in June, the best showing for Q2, mostly in line with expectations.  This outcome, however, is in nominal terms and, adjusted for inflation, real spending fell last month. The core data control group, which excludes items such as autos, food services, building materials and gasoline, increased 0.8%, the largest gain since January.

More on the store shelves but it’s happening slowly

Business inventories rose 1.4% MoM in May with wholesale inventories up 1.8% MoM and retail inventories higher by 1.1%.  The business inventory-to-sales ratio, a measure of the number of months of inventory on hand in relation to sales, increased to 1.3 months which was the highest since February 2021.  The sub-index for retail inventories rose to 1.2 months, which also was the highest since February 2021, however, it remains below the pre-covid 10-year average of 1.43 months.

Fed’s policy meeting is next week.  Will the Fed raise its funds target by 100 bps on July 27^th?  No.

We see a 75 bps rate hike firmly on the table for July.  After June’s CPI showed inflation accelerating sharply, speculation increased over the potential for a full point rate hike on July 27^th.  Fed Governor Waller and St Louis Fed’s Bullard, two key senior Fed officials and current FOMC voting members, held firm with their call for a 75 bps hike last Thursday, which immediately calmed the bond market.