Anyone following the Treasury debt markets over the past several weeks who is perplexed by the gyrations in yields should understand they are not alone. Since yields on the benchmark 10 year Treasury note bottomed out at 1.43% (a low not just for 2012 but since 1962) on July 25th, yields have moved sharply up and then sharply down. By August 16th, 10 year T-Note yields briefly flirted with 1.83% an increase of 40 basis points (bps). As we begin September, yields had retreated 27 bps to 1.56%.
Why the sudden surge and subsequent retreat in yields? Simply put, investors are of two minds on two important variables: the first is the economy's trajectory; and, the second is the Federal Reserve's commitment to another round of quantitative easing. Sowing the seeds of confusion was the Employment Situation Report (on August 3rd). The latest payroll figures suggested employment growth was stronger than the consensus expectation. Yields rose as investors reassessed the probabilities of continued expansion or a relapse into recession. [See the Chart of the Week for August 15th, entitled Temper that Exuberance for our analysis of the July employment report.]
The July payroll numbers fed a frenzy of speculation that the Fed's program of quantitative easing was over. As investors awaited the release of the Federal Open Market Committee (FOMC) minutes on August 22nd, they pushed rates higher still. When the minutes revealed the Fed was neither going to undertake another round of quantitative easing, nor commence unwinding QE1 and QE2, yields dropped and continue to fall. Finally, Fed Chairman Ben Bernanke's comments at the annual Jackson Hole conference of central bankers have been parsed to suggest another round of easing is imminent.
Despite the uncharacteristic tone of Bernanke's Jackson Hole speech, we do not expect another move soon by the Fed; nor, though do we anticipate that the Fed will unwind existing programs in the near future. We give three reasons for this view. While the Fed's purchase of mortgage-backed securities is intended to lower mortgage rates, it also absorbs some of the outstanding supply or mortgage-backed securities. Until the Treasury has figured out the government's role in the mortgage markets, we expect the Fed will accommodate this transition by holding Fannie Mae and Freddie Mac bonds. The second is that the economy is expanding, however, slowly. We suspect the Fed will hold off withdrawing liquidity until it believes all danger is passed. So, another round is possible but not assured. Last of all, we think the Fed will use the resurgence of core inflation excluding the influences of food and energy as a barometer. Sustained core consumer inflation should indicate final demand is expanding at a robust pace.
Short-term, the pace of consumer price inflation should accelerate as the effects of the drought percolate through the U.S. food supply. Rising prices at the grocery store will add froth to the inflation rate. But food only accounts for about 14% of the market basket upon which the Consumer Price Index for All Urban Consumers (CPI-U) is based. The head of steam over the next two to three years will come from the shelter component. Direct housing expenses at 31% of the CPI-U's weight are the single largest component in the index. A dramatic revival in the residential housing market is unnecessary to accelerate inflation; slow and steady progress will suffice. As residential vacancies tighten they are down from 2008 highs rising rents will filter through to the CPI-U. Demand growth may be anemic, but it is offset by a lack of new construction. Home abandonment and foreclosures further tighten the available supply.
Since hitting its nadir in December 2008, shelter costs have moved 4.2% higher. In the last twelve months the shelter component has risen 2.1%. If we are correct, declining residential vacancies will give rise to further rent increases. Inflation may be down, but it is not out.
Notes on Sources and Methods:
The Consumer Price Index for All Urban Consumers (CPI-U) is an index compiled by the Bureau of Labor Statistics (BLS) designed to track the aggregate cost of a basket of goods and services consumed by the average American household. The CPI-U is a widely quoted barometer of changes in the cost-of-living in the United States. The seasonally adjusted series incorporates smoothing of price movements arising from seasonal demand and supply considerations. The non-seasonally adjusted series is as the name suggests; not adjusted for such factors.
The CPI-U is composed of several sub-indices. The core rate is defined as the CPI-U less the food and energy components. These account for 14% and 10%, respectively, of the total basket. Another key component is the shelter index which represents just over 31% of the index. Economists at the BLS estimate shelter costs by monitoring rents nationwide; they also impute a rental cost for owner occupied housing. This owners equivalent rent is an estimate of the cost to the homeowner of renting his house. It represents almost 24% of the CPI-U.
(Source: Bureau of Labor Statistics; AIFS estimates.)
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