Treasury Market’s Inflation Outlook Tumbles

The Treasury market continues to downgrade US inflation expectations, which suggests that the case is strengthening for a rate cut by the Federal Reserve.

The widely followed spread for nominal and inflation-indexed 5-year Notes fell to 1.53% yesterday (June 12), based on daily data published by Treasury.gov. That’s the lowest implied inflation rate for this maturity since January 3. It’s also a forecast that’s well below the Fed’s 2.0% inflation target and the core rate of consumer inflation, which rose at an annual 2.0% pace in May.

Although the inflation outlook is subdued and appears to be edging lower, some analysts advise that macro conditions still remain neutral and so there’s room for debate on whether a rate cut is required. “Inflation at the current run rate neither prevents nor forces action on rates,” observes AllianceBernstein’s senior US economist Eric Winograd. “It is low enough to allow for rate cuts but not so low as to require them.”

Note, too, that it appears that US economic growth is stabilizing at a moderate pace for the upcoming second-quarter GDP report.

Yet the hard data on consumer inflation is showing signs of trending lower, albeit gradually. The core pace of the Consumer Price Index (CPI) eased to a 2.0% year-over-year increase in May, the softest gain in over a year and modestly below the previous peak: last July’s 2.3%.

Projections for core CPI’s annual trend in the months ahead points to a slow but steady slide, based on based on the average point forecast via The Capital Spectator’s combination-forecasting model. The estimate for core inflation in June, for example, is expected to edge down to 1.9% annual rate.

Economists at Bloomberg report that pressure is building for the Fed to react with new round of easing. “It will be a tough task for Fed Chair Jerome Powell to continue to attribute weakness in inflation to transitory factors when he answers questions at the post-FOMC meeting press conference next week,” note Yelena Shulyatyeva and Eliza Winger. “The latest CPI reading shows the monthly pace of core inflation extending its tepid streak, despite the key drivers of the recent deceleration — apparel and airfare prices — normalizing.”

Fed funds futures, however, are still pricing high odds that the central bank will leave its current target range — 2.25%-to-2.50% — unchanged in the June 19 policy statement. CME data this morning show a roughly 79% probability that Powell and company will stand pat next week. But the outlook shifts for the July FOMC. Fed funds futures are pricing in an 87% probability of a rate cut by next month.

A key factor in the rate-cut outlook is related to the ongoing US-China trade battle, says hedge fund manager Paul Tudor Jones. In an interview on Wednesday he predicted that a fresh round of monetary easing is near.

“I didn’t think we’d have a first cut in 2019,” he said.
“I don’t think we would have had that had we not gotten into this tariff
battle, and so it has accelerated everything.” He added that “the tariffs are
a very material event. We haven’t had any experience in modern times with them.
So you have to readjust the entire outlook.”