Inflation conundrum

Inflation data is rivaling nonfarm payrolls in terms of market enthusiasm lately as Wall Street tries to gauge when the Federal Reserve will make its move to curb asset purchases. The debate over transitory vs. persistent will continue through today as data on the input side arrives before the bell.

The Labor Department releases the July PPI report at 8:30 a.m. ET. Economists are predicting a headline rise of 0.6% for the month, with the annual rate staying at 7.3%. The core PPI, excluding food and energy, is expected to have risen 0.5% in July, with the year-over-year rate remaining at 5.6%.

Input cost inflation has been plagued by the same large price swings that the Fed has argued are transitory on the retail side, such as a spike in lumber prices, which has subsided, and a shortage of semiconductors, which is still a problem. And while companies have been announcing price increases through this and the last earnings seasons, there are concerns that more sticker shock is in store for consumers.

Tyson Foods (NYSE:TSN) CEO Donnie King said on the company's earnings call this week that Tyson has seen "accelerating and unprecedented inflation" and "costs are hitting us faster than we can get pricing at this point."

Ammo for both camps: Yesterday's July CPI numbers showed a cooler-than-expected core rise and moderate price gains in hot sectors, but a headline number still well above 5%. "Inflation has, at a minimum, paused," Brad McMillan, chief investment officer at Commonwealth Financial Network, told CNBC. "For both the headline and core figures, the monthly and annual numbers were stable or down from last month. Based on that data, inflation is certainly not on an unstoppable increase."

"The inflation data for July moderated somewhat, at least relative to the heady pace of recent months, which should temper market and policymaker concerns a bit, despite the fact that inflation will stay sticky-higher for a while and the risk to inflation from here remains on the high-side," BlackRock's Rick Rieder writes.

David Kelly, chief global strategist at J.P. Morgan Asset Management, said this was "still a very hot report" and that some of the higher prices will stick around for the rest of the expansion. "We're too obsessed with second derivatives here, we still have a five handle on inflation."

In a Bloomberg column this morning, Mohamed El-Erian, chief economic advisor at Allianz, says the report supports both sides of the debate. The transitory inflation camp will point to "the retreat of items that have been chief contributors to the surge in inflation, such as used-car prices and airfares," while those who worry about sustained economic damage from persistent inflation will point to higher food prices and the initial stages of wage-push inflation.

Overall, "it would be better to tilt toward what company after company has been saying about cost and price pressures rather than rely on macroeconomic models that inevitably struggle to capture pandemic-related changes," he says.

Whither yields? The Treasury market still remains a bit of a puzzle, with benchmark 10-year yields have risen 20 basis points in 10 days, but still historically very low for the kind of growth and inflation numbers the market is seeing. Yesterday provided another head-fake as the 10-year failed to take its cue from the CPI. Instead, it reacted much more to the strong demand for the $41B 10-year auction, where bid-to-cover was the highest since May 2020, which Jefferies called "one for the record books." This morning the 10-year (NYSEARCA:TBT) (NASDAQ:TLT) is down 2 basis points to 1.34%.

The "post-CPI reaction is a fairly classic sign of the market, albeit modestly, pushing back its expectations for when the FOMC may take their ‘foot off the gas’ and begin to taper asset purchases," Michael Brown, senior market analyst at Caxton writes. "I think, however, that such a view may be misplaced, given that yesterday’s inflation print was broadly in line with where the FOMC would’ve expected it to be."

Goldman Sachs cut its 2021 expectations for the 10-year yield this week, now calling for a rise to 1.6%, down from 1.9%. "In looking ahead, we expect erosion of labor market slack should continue to translate primarily to higher real yields, which we expect to be the main driver in taking yields towards our revised year-end target," Goldman said. "Notably, inflation out the forward curve is broadly priced at levels consistent with core PCE remaining around 2% (or higher), and while the delta variant poses some upside risks to inflation, our economists do expect pressures to subside over the coming quarters." (3 comments)