U.S. Inflation Remains High, Suggesting The Fed Has A Longer Fight Ahead

U.S. consumer prices are showing signs of easing, but expectations remain that the Fed may have to increase rates further to tackle inflation. Greg Bonnell speaks with Hafiz Noordin, Portfolio Manager at TD Asset Management, about the implications for fixed income markets.

Transcript

Greg Bonnell: The latest US inflation report shows that, while consumer costs are easing, it's going to take a while to get back to the Fed's target range. Joining us now for more on what it means for rates and the fixed income space, Hafiz Noordin, Portfolio Manager with TD Asset Management. Great to have you back on the show again.

Hafiz Noordin: It's great to be here.

Greg Bonnell: It's an interesting report, because, of course, the market reaction has been mixed trying to decide what to do with it. It wasn't very dramatic, but the big takeaway, I guess, I had, and I think others did, too, I want to get your opinion on it seems like this is a fight that's going to take a while. We know that, but there is nothing too dramatic here.

Hafiz Noordin: For sure, and I think what's interesting going into this particular CPR print was that what the theme that started to take a bit of a hold in the market and that Jerome Powell started to put forward was his idea of disinflation. It's starting to get kind of sanguine about this idea that, yes, inflation is going to come down. But for those who were going into today hoping for in-line or maybe a bit of a miss to the downside didn't get that, were disappointed.

It was an in-line print in terms of the month over month, half a percent on a headline basis, 0.4% on a core. But when you feed that into the year over year basis, it was a bit of a beat to the upside, 6.4 on a year over year for the headline CPI versus 6.2 expected by the market, and on core, 5.6 on a year over year versus 5.5 expected by the market. So I absolutely agree. The broad theme of inflation decelerating is certainly there compared to last year, but it's going to be a bumpy ride.

Greg Bonnell: I like the chart that we were just showing the audience in terms of where we were in inflationary pressures, and indeed, we have come off of those highs there as we're there between core and headline. But when you talk about that sweet spot, which is that dotted line along the bottom, that 2%, we, obviously, have a way to go. I know we don't have a crystal ball, but how long could it take us to get there?

Hafiz Noordin: Well, you know, I think one of the big forward-looking indicators that we have to factor in and what the market has been doing is shelter prices. It's about 40% of CPI. So what the market has generally been a bit more comfortable with is this idea that rent prices, which are a good forward-looking indicator, as well as housing prices themselves, do point to this idea that the shelter component of CPI, which lags a lot, it's very slow moving, and it's a very lagging compared to real time data. That should continue to chug down.

So that's kind of a known part of the deceleration story. The other part that's known is goods prices. So we know that we had this big sort of impact from supply chain disruptions over the post pandemic period, as well as higher commodity prices, generally speaking. So that really had this big impact on goods prices over a couple of years. That's now really come back towards more of a normal environment, where supply chain is really not an issue anymore.

So that's what's known, but what's unknown is the wage story. So for the rest of the services bucket, which is outside of housing, that's the part that's really sensitive to wages. And I think the pace of how we get to 2% really depends on do wages sustainably start to come down from their currently high elevated growth rates?

Greg Bonnell: Obviously, the average person isn't enjoying these price pressures. At the same time, as investors, the reason why we're so keenly interested in this is, of course, what does the Fed do with this information? What is the-- for a while there, it felt like the bond market was fighting back against the Fed to get the Chairman Powell, as you said, talking about disinflationary pressures taking hold. But we need to get rates even higher and hold them before other bond markets you'll be cutting before the end of the year. Is that story starting to change?

Hafiz Noordin: Yeah, in fact, the Fed's actually been almost kind of winning that battle a little bit in that we've seen market pricing for this year starting to get closer to the dots, and the dots were showing that stable rate at around the high fours, close to five. So that's where the market has started to move towards and is now actually moving further than that a little bit in that we're starting to see pricing in for 5.25% policy rate for the US, even early signs of getting to 5.5%. So I think that's where there's still, I think, this price discovery, so to speak, where it's going to be data by data point.

The jobs number kind of kicked it off a couple of weeks ago being very strong, showing that resilience in the labor market. Today's print is helping to accelerate that further to show that it's going to be a slow move back to 2%.

And I think what's probably the bigger, more important story, it's not just about is inflation coming down, but what is the floor? Is 2% really where we're going to land? I think there's just a lot of uncertainty around that. From some of the work that we do, that's not necessarily a done deal, you know? 3% to 4% is reasonable given the trends right now in housing inflation, but there's just a lot of price discovery around that trend.

Greg Bonnell: So when it comes to the Fed funds rate, if we do end up at a higher endpoint, the terminal rate is a little bit higher than we thought, perhaps, only a couple of weeks ago or a couple of months ago, and then, indeed, the Fed does stay there, once they get to that point, and they don't cut rates before the end of this year, how does that set up fixed income for this year?

Hafiz Noordin: Well, for the most part, the market's already kind of moved in that direction. So we have seen-- after an initial rally in bonds to start the year, we've seen a bit of a pullback in bond yields over the past few weeks. Part of that has been that repricing of the terminal rate for this year, but we still do see in market pricing for rate cuts next year. So it's still being fairly aggressive, so there's still potentially some room to go if the inflation data stays firm or if jobs data continues to be very strong. We could see a further pulling back of some of those rate cuts that are priced in for next year. That would primarily impact the short end and the sort of five year point of the curve, because that's the most sensitive to the Fed's policy rate and the expectations of the Fed policy rate over the next couple of years.

For longer dated bond yields, not necessarily impacted as strongly. We could still see yields going higher at the long end, but that'll be more sensitive to expected growth outcomes. So if we think that the market expects more of a chance of a recession to happen, because the policy rate has to be higher for longer, then we could actually see long bonds stabilize and potentially even decline if we're getting into that part of the cycle.

Greg Bonnell: Is part of the different story in the bond space this year, even though we're still unsure of exactly where we end up with central bank policy and inflation, is the fact that they're actually showing us some pretty attractive yields for the first time in a very long time?

Hafiz Noordin: For sure, I mean, it's almost double compared to last year. So your starting point as a fixed income investor is still that very high level of income, 4% to 5%, depending on where you're on the curve. And then, at the same time, if you're getting that duration or interest rate risk in your portfolio from being a little bit out the curve, that helps to provide in a recessionary environment, a boost to your total returns if yields do then start to come down. So definitely, the risk/reward has skewed much more in favor of positive total returns for fixed income. Still, you have to be mindful that there will be volatility along the way with the incoming data.

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