The market premium for the US 10-year Treasury yield rebounded sharply in January, rising to its highest level in nine months, based on a “fair value” estimate calculated by CapitalSpectator.com. Yesterday’s hotter-than-expected inflation data for last month suggests that the market premium will remain elevated for longer than recently expected.
The current market premium over the average fair value (based on the average of three models) rebounded to 104 basis points last month, the most since last April. As a result, the January estimate reverses a recent slide in the market premium that had taken the estimate down to levels that were in line with the “normal” range that prevailed before the pandemic. Firmer inflation expectations are the likely key factor. As noted in last month’s update, so-called sticky inflation risk has recently reversed the downward trend in the 10-year yield’s market premium. Yesterday’s news of an acceleration in consumer price inflation will probably strengthen and support this reversal in the near term.
Focusing on how the market premium or discount varies through time raises the possibility that the elevated level of late may not normalize anytime soon. That’s a change from recent history when ongoing progress with taming inflation rolled on. But as this progress has stalled, the market outlook is adjusting. For a period following the end of the pandemic, there was a case for expecting that elevated premiums were temporary.
But as the Federal Reserve continues to struggle to complete its mission to bring inflation close to its 2% target, an elevated market premium for the 10-year yield now appears likely to persist.
Focusing on inflation data, as a result, is increasingly the dominant factor for evaluating the 10-year yield outlook. Yesterday’s consumer price index (CPI) at the headline level picked up to a 3.0% year-over-year pace through January. That’s the highest increase since June and marks the fourth straight month of faster inflation. Core CPI, a more robust measure of the trend, also ticked up to 3.3%.
Core CPI remains in a low-3% range and so this measure suggests that sticky inflation doesn’t appear set to transition into a new regime of rising inflation in the immediate future.
But as discussed in yesterday’s US Inflation Trend Chartbook, there are several worrying signs to consider. (Note: the Inflation Trend Chartbook is sent to subscribers of The US Business Cycle Risk Report, but for this month readers can view the current issue the inflation report here.)
One example of what may be a worrying start to an extended pickup in inflation is the ongoing rebound in the average of conventional and alternative CPI indexes. Combining the standard headline and core CPI metrics with five alternative measures published by regional Fed banks highlights an ongoing firming in pricing pressure. This measure of the inflation bias for consumer prices rose for a fourth straight month in January.
A similar warning can be seen in another proprietary measure of inflation bias via The Inflation Expectation Bias Index.
The next chart below shows the average monthly change of the one-year differences for 1-, 2- and 3- 3-year-ahead inflation expectations via models developed by the Cleveland Fed.
There are other metrics that suggest that it’s still premature to assume that the inflation trend is now rebounding and so the outlook remains open for debate. But at the very least this much is clear: sticky inflation is a conspicuous risk for the immediate future and there’s a danger that, if left unchecked, could turn into a rising period of pricing pressure.
Complicating the outlook are White House plans for raising tariffs, which tend to be inflationary, if only as a one-off event.
For the moment, Fed funds futures are still pricing in a high probability that the central bank will leave its target rate unchanged at the next policy meeting on March 19. But a lot can happen between now and then and some observers are starting to wonder if a rate hike may be brewing at some point in the near term.
As usual, much depends on the incoming data. With that in mind, all eyes will focus on the next consumer inflation report. The February data is scheduled for release on Mar. 12, a week ahead of the next FOMC meeting. If the Fed is falling further behind in the battle to tame the last mile of inflation, the February CPI report could be decisive for tipping the scales in favor of a new round of tightening.