Pause
As the (proverbial and literal) smoke cleared after America celebrated its 250th birthday, new flares arose as tensions and attacks escalated in the Middle East—and with them, fears of a return to full war. The latest news of decelerating inflation makes the economic picture even hazier.
Thankfully, Plain White T’s brings us some economic truth. Garnering 6.4 million views on YouTube, the Illinois band’s upbeat song “Pause” suggests that the Federal Reserve will be “callin’ time out, plenty of time to figure it out, gonna push pause” on any rate hike decision at the upcoming July meeting.
Indeed, last week’s inflation data was weaker on balance; signs of nascent deceleration in pricing pressures emboldened most market pundits to gravitate toward Plain White T’s message. There is, of course, one fly in the ointment to this outcome (i.e., no hike or cut): Fed Chairman Kevin Warsh has yet to offer any clues on his thinking—and he likely won’t, given his preference to keep the Fed’s cards close to the vest.
Just after the Consumer Price Index report was released, Warsh gave his first testimony to Congress. Although occupying the Fed Chair seat for only two months, Warsh had to answer a wide variety of questions about the economy and monetary policy. The sticking soundbite from his testimony came after he said that policymakers at the central bank have no tolerance for high inflation, reiterating a vow to tame price growth that has been elevated for five years. “The members of our committee have no tolerance for persistently elevated inflation … we share a resolute commitment to restoring price stability.” He continued, “If we get policy right—and we will—the inflation surge of the last five years will be a thing of the past.”
In June, consumer prices fell by the most in six years, according to the Bureau of Labor Statistics. This news prompted bond market traders to unwind bets of a July rate hike at the upcoming Federal Open Market Committee meeting that concludes on July 29. The CPI declined by 0.422%, month over month, in June (white line in Figure 1), dragged down by a large decline in gasoline prices. The drop in energy costs (red bar) followed the previous momentum for ending the war in the Middle East, momentum that now seems fragile.
Excluding volatile food and energy prices, inflation was flat (blue line), which is also a welcome outcome. However, because the CPI is backward looking, some of the recent relief at the pump from fading geopolitical risks are likely to reverse with renewed hostilities. “The very benign June CPI inflation report gets Warsh off the hook in terms of pressure to hike near-term and allows him to position the Fed as resolutely committed to bringing inflation back to target without fueling expectations of a July move,” wrote economists at Evercore ISI.
Figure 1: Contributions to June CPI, 2021–present
Source: Bloomberg
Core services, which include the heavyweight shelter component, contributed much less in June when compared to recent months (Figure 2). Much of the decline was attributable to declines in medical, transportation, education, and communication services. Per the heatmap in Figure 2, these declines seem to be more of a one-off event, evidenced by recent oscillations between positive and negative contributions. This observation piggybacks off a previous Talking Points’ chart, where spikes in medical costs and financial services fees contributed greatly to the headline figure, only to recede in the following months.
Thankfully, the shelter index seems to be entering somewhat of a more stable decline, as evidenced by a 0.301% month over month contribution in April, followed by 0.177% in May and 0.019% in June. A downshift in housing sector prices will be a celebrated change from an inflationary point of view. But such a downshift also comes with some risk because housing makes up a large portion of the U.S. economy.
Figure 2: Core services’ contributions to CPI, 2021–present
Source: Bloomberg
In a separate release, the BLS reported a tepid annual gain in hourly earnings of 0.1%, month over month, after adjusting for inflation. The barely positive figure was clearly buoyed by the drop in pricing pressures, and the index warrants further monitoring. For context, consumers had been enjoying slight inflation-adjusted wage growth of about 1%, on average, from 2023 until the recent energy spike (Figure 3), which then put pressure on real incomes.
So far, historically positive wage growth (assuming the energy problem is transitory) and still strong labor figures will give the Fed enough reason to keep the scales tilted in a hawkish direction. Yet any deterioration in these figures could easily move the needle the other way.
Figure 3: U.S. inflation-adjusted hourly earnings, 2016–present
Source: Bloomberg
So far, though, there is reason to remain sanguine about the economy. In his testimony, for example, Warsh was generally upbeat and noted minimal signs of layoffs, as well as solid wage growth. Similarly, minutes of the FOMC’s June 16–17 meeting reflected receding worries about the labor market, but growing concern over inflation.
“[The latest inflation] print takes a July hike off the table,” argued Zach Griffiths, head of investment grade and macro strategy at CreditSights. “While inflation is still too high and the situation in the Middle East is deteriorating, [last week’s] data should give them enough cover to stay in wait-and-see mode.” Other pundits agreed. “This [inflation news] will relieve some pressure on the Fed to hike rates this year,” said Tracy Chen, portfolio manager at Brandywine Global Investment Management. “But with the new norm on the Iran war front, we might not be out of the woods yet.” Federal funds rate futures markets are pricing in line with the ideas espoused by Griffiths and Chen, deleting nearly half a cut in next summer’s policy rate (Figure 4).
Figure 4: Fed funds futures rate hike estimates, before and after June CPI and PPI releases
Source: Bloomberg
During questioning from lawmakers, Warsh, as noted, struck a hawkish tone. “As we look out the window now, the labor markets look to be in pretty good balance. We’ve got some work to do on the inflation front.”
Still, one of the unknowns at this moment is just how much Warsh is willing to play ball regarding forward guidance. “I think being somewhat more circumspect in our communications … is a better way of calling balls and strikes,” he said.
Last week, Lument’s Trading Desk met with an investor who believes that Warsh’s affinity for less forward guidance will put every FOMC meeting in play, much like in the Alan Greenspan era. This will likely lead to more volatility on FOMC meeting days, as markets are forced to digest the entire meeting as opposed to bite-sized hints along the way.
When Plain White T’s returns to Illinois this week to play in Decatur, we doubt that the band will cast an explicit opinion on monetary policy at the Devon Lakeshore Amphitheater. But they may still offer a hint at their views with lyrics such as these: “I don’t know, where this road is gonna go. I’ll be just fine, taking my time.”
FROM THE DESK
Agency CMBS — Volumes were low again last week, with only about $600 million Fannie Mae DUS and $270 million Ginnie Mae newly issued. Investor bids reflected the low supply environment. Fannie spreads were flat to 1 basis point tighter and Ginnie spreads were 2 bps tighter, week over week.
Municipals — AAA tax-exempt yields moved higher across the curve for a second consecutive week. Primary issuance increased following the holiday-shortened week, while demand for longer maturities softened modestly, pushing rates higher. Despite the backup in yields, overall market technicals remained favorable: Municipal bond mutual funds recorded a third consecutive week of inflows exceeding $1 billion and investors received additional reinvestment cash from July 15 coupon and maturity payments. Tax-exempt valuations remain rich relative to Treasuries, with the 2-year muni-to-Treasury ratio at 58%—compared to a 1-year average of 62%. Meanwhile, the 30-year ratio stands at 84%, versus a 1-year average of 89%. Municipal bond mutual funds attracted approximately $1.4 billion of inflows during the week, including $265 million into high-yield.
ECONOMIC CALENDAR FOR THE WEEK AHEAD
Source: Bloomberg. P = preliminary; F = final
Source: Bloomberg
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