Core Services Pushing Inflation Higher Than Expected

Core Services Pushing Inflation Higher Than Expected
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Core Services Pushing Inflation Higher Than Expected

The core Consumer Price Index (CPI) May data released today reminds us that underlying inflation in the U.S. is robust. Growing at a seasonally adjusted 0.203% month-over-month and 2.24% year-over-year, core CPI is running even higher than we thought a year ago when we were forecasting core CPI at 2%.

Once again, strength is coming from the domestic economy. Core service prices have increased by 3.2% since last year. Core services accounts for 60% of the CPI basket, the largest component of CPI. Core goods, which represent only 20% of the CPI basket, were down 0.5% from last year, once again the biggest headwind. Meanwhile, the drag from low energy prices, 9.8% cheaper than a year ago, still weighs on headline inflation. When everything was said and done, headline CPI rose 1% year-over-year.

Looking at the TIPS (Treasury Inflation-Protected Securities) market reaction, with 10-year breakevens trading at 1.46% – down 5 basis points from yesterday – you might conclude market participants put more weight on headline inflation than core inflation. This is surprising because while headline CPI is notoriously volatile, core CPI is a much better indicator of the underlying inflation trend. The best illustration of that point is July 2008, when headline inflation was running at a steamy 5.6%, only two months before Lehman Brothers went bankrupt.

Since 1990, the correlation between headline inflation and the average headline inflation for the next five years is 0.38, but it moves to 0.54 if we use core inflation (versus the same average headline inflation for the next five years). In other words, core CPI is statistically more significant for predicting inflation than headline CPI.

So while one would think core CPI running at 2.2% would have convinced investors to increase their allocation to TIPS and rush for those cheap breakevens, most market participants remain focused on risks from Brexit and also our more secular theme of increased uncertainties.

Which leads me to my last point: While the Bank of Japan isn’t credible when saying it rejects helicopter money, Fed Chair Janet Yellen doesn’t seem offended by the unorthodox idea. “There might be a case for, let’s say, coordination – close coordination with the central bank playing a role in financing fiscal policy,” she said at a press conference yesterday. If this abnormal, indeed extreme situation were to come to pass (and who would have thought that 10-year German debt would be yielding negative rates?), some investors might wish they allocated more of their portfolio to TIPS.

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Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.