The producer price index showed a meaningful jump in inflation for the second month in a row in April. PPI rose by 2.1% over the previous year. That’s the highest rate of increase since March of 2012, and just slightly above the Fed’s 2% long term inflation objective. Judging by this indicator there isn’t severe inflation, but there is inflation. This and a number of anecdotal comments from management teams during the most recent round of earnings calls suggests that at the very least, inflation is percolating.
Against a backdrop of rising inflation, you’d think that interest rates would start to rise as well because interest rates should reflect inflation. You might think that, but you’d be wrong.
Longer term interest rates continue to slide in 2014 and the U.S. 10-year Treasury yield has fallen to 2.54% from 3% to start the year. Curiously, rates have seemed to decline most violently on days that data would usually imply they should do the opposite. Not only did rates sell off today on strong inflation data, they also sold off at the beginning of the month on strong employment data.
Even though it seems bizarre, there is precedent for interest rates to disconnect from inflation. Between 1914 and 1960 there were three periods that the Fed held interest rates below the prevailing rate of inflation. Two of the three were in war times, the third was in the depression. Looking at these historical periods, there is no doubt that the Fed does have the power to keep interest rates below the inflation rate for a long time if it decides it wants to.
Falling long term interest rates are telling you one of two things:
- Either people expect the inflation rate to fall from here (the “fundamental” viewpoint) or
- The Fed will continue to anchor interest rates for a long time (the “command control” viewpoint).
If you believe the first, then you probably shouldn’t have a particularly bullish outlook for earnings, because how great can earnings growth be in an environment where inflation can’t hold 2%? If you believe the second, then you really have to accept that the Fed is the single most influential force affecting securities markets today. Regardless of the fundamentals, securities markets are clinging tightly to the Fed’s policy. Long term rates really began to fall around the same time that Yellen assured us that we should expect them to stay there for the foreseeable future.
This is Yellen’s world, we’re all just living in it.
Disclosure: The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.