Interest Rate Market Commentary: Path to Dis-Inflation

February 23, 2023

The short story: we are still on a dis-inflation path – slower but still downward.   

By Serafino Tobia, Managing Director & Head of Agency CMBS Trading, Greystone

The 10-year Treasury sits at 3.92%, likely at the high-end of a range, perhaps as the markets overreact a bit to the payroll report and firmer economic data. The short story: we are still on a dis-inflation path – slower but still downward.   

A month ago, the 10-year Treasury was at about 3.50% and on 2/1/23, after the Federal Open Market Committee (FOMC) Meeting, the 10-year moved down to 3.36% intra-day, 3.39% close of business on 2/2/23.  There was a narrative in the markets about “dis-inflation” taking hold. Fed Chairman Powell spoke about dis-inflation and economic activity moderating (true, the CPI year-over-year headline rate stood at 6.5% for December, down from 7.1% in November, 7.7% October and 8.2% in September).

But, not so fast. Just two days later, market sentiment changed with the very outsized employment report.  The employment report for January showed 517,000 new non-farm payroll jobs, 2.75 times the consensus estimate of 188,000 job growth. The unemployment rate registered at 3.4%, a 50-year low. In other words, there’s no sign of a slowing economy and exactly the opposite of what the Fed is trying to do with raising the Fed Funds rate. Since then, we got January’s CPI, PPI and other economic data (like a 3% increase in retail sales month-over-month), all of which indicate that economic conditions are just fine and that the improvement we had seen with the monthly inflation prints is stalling.

The January CPI report dropped to 6.4%, Core CPI (CPI without food and energy) was also 1/10th of 1% lower at 5.6% vs. 5.7% in December. CPI month-over-month came in at 0.5% (6% annualized). Core CPI month-over-month was 0.4% (4.8% annualized).  

The discussion about the economy has gone from “recession” a few weeks ago, to “soft landing recession” and now, possibly “no-landing at all.”

While we have seen consumer prices gap lower by ½ of a percent each month the previous 3 months; January’s number suggests inflation will stay elevated. In other words, we shouldn’t expect inflation to come down to the Fed target of 2%-2.5% so quickly – particularly with wage and services inflation. There is some basic Phillips Curve math at work here--- a 50-year low in unemployment rate isn’t helping the wage inflation to moderate.  

Fed Funds Rate Moving to Over 5%

The Fed will look at the outsized January job report and wage inflation as a reason to stay on the track of moving the Fed Funds rate higher (Powell indicated that there will be further increases – plural – in the Fed Funds rate).  

That likely means at least two 0.25% increases – one at the March FOMC meeting and one at the May meeting, reaching 5%-5.25%. Two of the regional Fed Presidents, the St. Louis Fed President James Bullard and Cleveland’s Loretta Mester are both advocating for higher fed fund rate increases. Some economists, like Matthew Luzzetti, Deutsche Bank’s Chief US economist, are now forecasting the Fed to keep moving rates higher through July with a terminal rate of 5.60%. Luzzetti’s point is that the Fed wants to use rates to slow the demand for labor and since the labor market hasn’t reacted yet at all to the Fed tightening so far, so the Fed will need to go further. We expect the Fed will be highly dependent on the economic data reports, as always, such as GDP (Gross Domestic Product), PCE Price Index, and home sales numbers, and another jobs report, CPI, PPI in March before the next FOMC meeting. 

Where Do Treasury Rates Go from Here?

Treasury rates will be dependent on economic data as well. We have had a re-trace of higher rates since the outsized employment report. 2-year Treasuries were at 4.10% on 2/2/23 and now stand at 4.70%. Back in early November, the 2-year was at 4.72% - so we are right back to that point.    

Again, 10-year Treasuries are at 3.92%, they were at 3.39% at the close on 2/2/23 and back in early November, the 10-year was as high as 4.21%. Before the outsized employment report and the most recent string of economic data, it was likely the 10-year Treasury would stay in a range around 3.50% on the basis that a dis-inflationary period was underway but that getting inflation down below 3% would be difficult (and that would be needed to justify an even lower 10-year rate). That’s likely still the case for the most part. We don’t expect 10-year rates to move much higher from here, primarily because inflation is likely not re-igniting.

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