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Markets baulk as the decline in US inflation stalls
All eyes were focused on this week’s US CPI inflation report for the month of March with both headline and core CPI surprising to the upside. Most of the surprise was due to higher core prices, which rose by 0.4% m/m vs market expectations of 0.3%, which in year-ended (i.e., annual) terms translated to an unchanged rate of 3.8% vs market expectations for a decline to 3.7%.
Even though the miss was relatively small (just 10 basis points (bps)), financial markets were spooked by the momentum in the monthly core inflation reports. That momentum has seen inflation rise steadily from 0.2% (monthly, or 2.4% annualised) back in June 2023, to 0.4% (or 4.8% annualised) by January this year, and then holding at 0.4% over February and now again in March.
The market reaction was sharp, with US 10-year bond yields rising by around 20bps and the S&P 500 falling by around 1% (but subsequently recovering). Australian markets were not left unscathed, with Australian 10-year bond yields up by around 16bps, the S&P/ASX 200 down around 0.7% and the Australian dollar down a little over 1%.
Of course, the market appears to have overreacted to a relatively small miss in the March inflation print. Delving into the detail of the report, much of the miss can be attributed to motor vehicle insurance, which jumped 2.6% over the month, contributing 9bps to the core result.
In fact, over the past year, we have seen motor vehicle insurance prices rise 22% in the US, the highest gain seen since 1976. The higher insurance costs partly reflect the run-up in vehicle prices seen following the pandemic.
With new vehicle prices stabilising and used vehicle prices now in decline, we can expect the cost of motor vehicle insurance to abate with a lag. Nonetheless, just as in Australia, US core inflation remains sticky as inflation of services sector items, such as rents and health services, remain stubbornly elevated.
The stickiness of the services sector inflation, which has slowed the pace of disinflation in the US, has caused bond markets to reassess interest rates. For example, since their low point at the close of last year, US 10-year bond yields have risen by around 75bps from 3.80% to 4.55%.
Real bond yields (which are important in determining valuations of risk assets such as equities) have also risen by 50bps from a low of 1.65% at the end of last year 2.15% currently. A key question for financial markets is where interest rates will settle in the longer term. Is the recent bond selloff an overshoot, or is it indicative of a new higher and more permanent interest rate regime? As the US economy slows, will we see nominal 10-year bond yields retreat back to rates closer to 3% than 4% and real bond yields fall back to rates closer to 1% than 2%?
Interestingly, we can infer the view of the US Federal Reserve (Fed) from their Summary of Economic Projections (the so-called dot plots) last released following their March FOMC meeting. In that release, the Fed’s longer run (after 3 years) estimate of the fed funds rate (the infamous r*) was 2.6%.
If we add a 50bp term premium to the 2.6% fed funds rate, we get an inferred Fed estimate of a long-run nominal 10-year bond yield of 3.1%. Assuming, as does the Fed, that in the longer run inflation is at the Fed’s target, the longer run inferred Fed estimate of the 10-year real bond yield is just 0.8%.
To put these numbers into context, the US 10-year real bond yield averaged 0.6% over the decade prior to Covid; a decade characterised by a zero fed funds rate and US$4 trillion of quantitative easing. Are we likely to see a return of interest rates back to the post-GFC/pre-Covid levels?
We don’t think so. Although the current surge in interest rates has the hallmark of classic late-cycle behaviour, the future for US 10-year yields is for nominal rates closer to 4% than 3% and real yields closer to 2% than 1%.