In June 2003, the 10-year Treasury did something extraordinary by yielding around 3.07% at one point in that month. That was a generational low, and it’s proven to be the nadir for the 10-year ever since. Judging by this morning’s report on producer prices, the odds improved again for 3.07% remaining the low for the foreseeable future.
As of last night’s close, the 10-year’s yield was some 200 basis points higher from the low of three years ago. The great question coursing through the financial markets is whether the elevation that the price of money has accumulated over the past 36 months will suffice to stifle the mounting inflationary pressures that appear to be bubbling in the economy.
Producer prices advanced by 0.5% in June, the Bureau of Labor Statistics reported today. In addition to being well above the consensus forecast, 0.5% represents a sizable jump from May’s 0.2% rise. On the other hand, the core PPI (which removes energy and food from the mix) slipped a bit last month, increasing by 0.2%, down from 0.3% the month before.
If any of this gives investors reason to wonder about the primary trend in wholesale prices, a rolling 12-month gauge of PPI offers a more-enlightening picture. On that score, there’s reason to worry: PPI has climbed 4.8% over the past 12 months, the second-highest rate this year. Yes, the trend looks less ominous after subtracting energy prices. But in the real world, we all consume energy and pay market prices, ensuring that energy’s threat on inflation is more than theoretical.
Granted, there’s a sizable risk premium built into the price of oil these days. Neil McMahon, an oil analyst in Sanford C. Bernstein’s London office, writes in a research note to clients today that a $27-a-barrel premium is embedded in crude’s price. “In the absence of the perceived risks the market is factoring in, we believe prices would be below $50/bbl based on the supply demand balance, and current levels of spare capacity which has been steadily expanding for the last 12 months,” he writes.
All of which highlights the same old challenge facing the Federal Reserve: to hike or not to hike. If oil was priced purely by supply and demand, inflation fears would be considerably tempered. Meanwhile, there are expectations that an economic downshift may be coming, in which case more inflationary momentum may be curtailed. But the Fed can’t wait for such macroeconomic aid, nor is Opec about to start pricing oil based on what economic fundamentals imply.
Indeed, the immediate reaction to the PPI report this morning has been one of selling the 10-year Treasury, thereby pushing its yield up to 5.13%, the highest since last Tuesday’s close. Erring on the side of caution, in short, is popular sport in bond trading today.
The Fed, however, may find it more difficult to be so single-minded. Finding the sweet spot between expectations of an economic slowdown and bubbling inflation in the here and now is Bernanke and company’s primary challenge. Second guessing what comes next when the Fed meets next on August 8, futures traders have surmised that another 25-basis-point hike to 5.50% remains a distinct possibility.
But make no mistake: we are close to the end of the current rate tightening cycle. Minds differ over how close. No, we won’t see 3.07% on the 10-year Treasury soon, if ever, but might see 4.5% again in 2007?
Economic growth isn’t poised to accelerate. The jury’s out on whether that’s also true for inflation. Nonetheless, we suspect that over the next 12 months, there will be new opportunities to take advantage of the economy’s downshift by readjusting asset allocations in fixed-income. But first we must survive the summer, which is proving to be hotter than predicted. Tactics are in, for the moment; grand ten-year strategies are out.