Inflating

Well, if you thought peak inflation had been reached, the May U.S. Consumer Price Index certainly did not show that to be the case. And the markets are not a fan. U.S. CPI rose 1.0% in May, which brought the one-year tally to +8.6%. One little silver lining is that core CPI (excluding Food and Energy) was 6.0%, which is down from last month’s pace of 6.2%, marking its second month of declines. But really it was hard to find good news with this inflation print.  This has clearly pushed equities lower as the timing of central banks slowing their rate hike pace has certainly moved out later into the future.

And while this was a U.S. economic release, the impact has been global. In response, bond yields moved higher in the U.S., Canada, Europe, and elsewhere around the globe. The move is about 10-15bps at the time of writing, which has the U.S. 10-year at 3.17% and the Canada 10-year up even higher at 3.35%. Once again, that makes for a drop in equities and bonds, which is not something anyone likes. 10-year yields are now a decent amount over 3% and are at a pretty critical level.

This has certainly opened the door for the Fed to not just go for two 50bps moves in the summer meetings; it could mean we see a bigger move or even keep the 50bps pace up longer. And after yesterday’s Bank of Canada Financial System review, it seems that the rate hike paces are unlikely to let up anytime soon. The futures market is now pricing in an overnight rate in Canada of 3.39%, compared with the current 1.5% level. The Fed futures really jumped on the CPI, with the year-end forecast at 3.1% compared with the current 1.0% level.

There is some encouraging news out there though. China Producer Prices continue to come down, which feeds into a lot of pricing further down supply chains. And while inflation is all the rage again, and clearly not going away just yet, break evens beyond the next 12 months certainly points to cooling…at some point. Break evens represent the amount of inflation priced into the market during certain periods. As you can see, the one-year implied inflation had been coming down but spiked on the CPI print. But once again, the two- to five-year period remains muted.

Investment Implications

We continue to believe the inflationary impulse will begin to fade later this year, but it certainly won’t be smooth. The economy works in waves and some waves move faster than others. Higher financing costs and financial conditions are now starting to slow economic activity. The wave or impact has a certain speed. The subsequent slowing of inflation is another wave that takes even longer, but we do believe it is still coming.

Given most portfolios tend to be much shorter duration than the overall bond market, we would continue to recommend taking advantage of the rising yields by adding some duration back into the portfolio. Not all at once, but in stages.

— Craig Basinger is the Chief Market Strategist at Purpose Investments

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Sources: Charts are sourced to Bloomberg L.P.

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