Inflation Moderating Yet Bond Yields Up?

A: What gives? In a perfect world, the inflation data that came out this morning via a mild PPI # told the street that the fed would have an easier time cutting interest rates since inflation seems to be moderating? Right? Not exactly. If this were true, the yields on most bonds would be falling to anticipate future lower interest rates. But that is NOT what is happening? So what is really going on?

The pipeline is what is going on! While the PPI report came in ahead of expectations in terms of inflation worries, its what is yet to come that is still worrisome; there are still signs of trouble in regards to inflation and a few moderate reports does not a trend make. Let the street applaud the temporary relief in inflation with higher stock prices, but I'm not convinced yet and neither should those expecting lending rates to dip on this news!

According to CNN Money:

The Producer Price Index, which measures the price of goods at the wholesale level, rose 0.7 percent last month, down from a 1.0 percent gain in March, the Labor Department reported. Economists surveyed by Briefing.com had forecast a 0.6 percent rise.

But the more closely watched core PPI, which strips out volatile food and energy prices, showed no rise after also coming in unchanged in March. Economists had forecast a 0.2 percent increase.

The report showed that energy prices jumped 3.4 percent in the month, while food prices rose 0.4 percent. Both were down from the increases posted in both February and March.

The overall PPI is now up 3.4 percent over the last 12 months, while the core PPI is up only 1.6 percent over the same period. The Federal Reserve is generally believed to want to see core inflation readings in the range of a 1 to 2 percent increase on an annual basis.

But here is the real good part...

Mark Vitner, a senior economist with Wachovia, said the PPI report has some readings that justify the Fed's concern. The overall and core PPI is for finished goods such as bread but prices for crude goods such as wheat and intermediate goods like flour are also measured. Prices for intermediate goods jumped 0.9 percent, while prices for crude goods excluding food and energy climbed 0.4 percent, pointing to inflation pressures in the pipeline.

"The Fed is not going to say 'We have to cut rates because consumer spending was weak in April,'" Vitner said. "They're right that inflation is still higher than they'd like. The best way the Fed can keep higher energy prices from spilling over is to hold the line on rate cuts."

Fact is, we are far from easy street in terms of inflation and as long as this is the case, you MUST NOT count on easing interest rates in your investment decision making. Keep in mind that inflation pressures have been dogging around for almost 2 years now, so don't think for a second that a couple of moderate reports such as this last one is going to solve everything!

While short term bond yields dipped on this latest inflation news, the 2YR / 3YR / 5YR / 10YR / 30YR all rose a bit signaling that the bond market is not buying into an easing inflationary world. If it was, all yields will be falling as expectations that the fed can lower rates take hold. You see, the main reason why the fed CAN'T lower rates right now is because of inflation. High energy prices, high food prices, high commodity prices are all contributing to this dynamic. As long as these fundamentals stay at these levels, all the fed can do is HOPE that an economic slowdown resulting from these higher costs in itself eases inflationary pressures. If it works out this way, you will see energy, food prices, and commodity prices all fall. This has not yet happened.

Stocks still seem to be the market of choice for investments although short term CD's and even some online savings accounts are offering no risk 5% returns. With a continuing weak US dollar, the fed is stuck with leaving rates unchanged. The only thing that will change this is if the housing market gets so bad that consumers stop spending and the economy completely derails; which will force the fed to cut rates to settle things down. If this should happen, I don't see how stock prices will hold onto their recent gains given all the uncertainty that is to come with this scenario playing out.

Time will tell. For now, you need to know that inflation STILL EXISTS and the fed will keep rates unchanged. Don't bet on lower rates yet to bail out out housing market. Perhaps towards years end.

Expect lending rates to see-saw around current levels heading into Tuesday's CPI report, which will tell us more detailed information on the inflation front. Looking back, I cannot recall a more confusing time in terms of future monetary policy direction than what we are in right now. I have been following this stuff obsessively since 1992 or so and right now we seem to be in a war between those that think the US economy is in the midst of a serious slowdown mostly from housing woes, and those that think the US economy is still strong but inflation is hiding and waiting to attack. Where interest rates go depend on how the ivy leaguers at the fed interpret the data, so that is our best chance of making the right bets and investments in the near term. Don't fight the fed.

Keep in mind one very important factor, that monetary action lags by a good 12 months or so! We are still waiting for the FULL EFFECTS of monetary action to funnel through the economic system. In my opinion, the fed is waiting to see the full effects of what they have done so far. In the coming months either the US economy will slow enough to ease inflation OR it won't. It will be the answer to this question that I think will dictate the next move. The jury is still out on whether Bernanke & Co. are true inflation hawks, and the next 3-5 months should reveal the hand they have been playing since pausing with their 2+ year interest rate hike campaign. You would be wise to keep tabs on this!