Inflation News Gives Bonds the Blues

This past week interest rates spiked to the highest levels since November. Let's review what happened and what to watch for in the week ahead.

Higher inflation, Higher rates

The high-impact Consumer Price Index (CPI), a closely watched gauge of consumer inflation, was reported higher than expectations. The headline reading, which includes food and energy, was expected to come in at 2.9% year-over-year, but instead came in hotter at 3.1%.

The all-important core reading, which excludes food and energy, came in at 3.9% year-over-year, still well above the Fed's target of 2%. Bonds and rates loathe inflation, and they didn't like this number. In response to the reading, the 10-year yield spiked from 4.18% to 4.31% in the matter of moments. And mortgage-backed securities, which drive mortgage interest rate pricing, fell to their lowest levels since November.

What caused the high reading of inflation? Shelter. The shelter component of Core CPI made up nearly 70% of the 3.9% climb in prices. There has been a lot of speculation that rents are declining, and it takes time for it to seep into the consumer price index. We haven't seen that happen just yet.

Fed's Next Move

This hot inflation number certainly creates an issue for the Fed. Back in 2022, the Fed said there would be "pain" and that higher rates were needed to slow economic growth and elevate unemployment so that it could tamp down demand and lower prices. Here we are seven months after the 11th rate hike and unemployment remains below 4% and inflation is near 4%. Yes, prices have come down from much higher levels, but did the Fed rate hikes make that happen? Looking through this lens, one would ask, how does the Fed cut rates? They will certainly not cut in March and right now the Fed Funds Futures have already removed two of their six forecasted rate cuts this year from the table.

This uncertainty and volatility surrounding economic readings and the Fed's next move is what has increased instability in the bond market and interest rates.

Japan Enters Recession

Last Thursday, Japan, the world's third largest economy, reported it entered a recession. This is happening just as China is mired in an awful deflationary slump and property crisis. Recessions generally lead to low economic activity and lower inflation. So, if the globe slows down and prices decrease, we import lower prices which could help limit how high rates increase.

Price Discovery Mode

Last week, the 10-year yield broke out of a range, and above 4.18%, which led to a spike in yields. The market is in price discovery mode, trying to assess what bonds and interest rates are worth with inflation threatening to move higher. Soft economic data will allow rates to come back down. The opposite is true.

Bottom line: Interest rates broke above key levels and are now waiting for the next high-impact reading to determine whether this spike and yield is justified or not.