Inflation is one of the basic building blocks of bond yields.  A bond is a loan… an agreement for you to give me a lump sum of cash today and for me to pay you back with periodic installments over time.  If inflation means dollars have less buying power in the future, more inflation means those future installment payments are relatively less valuable.  If that makes great sense to you, skip to next heading a few paragraphs down.  If not, here’s an example to bring it home:

Let’s say you need a loan for \$1200.  I’m going to give you the cash and you’re going to make 12 monthly payments of \$100 each (0% interest, because I love you that much!).  I will use each \$100 payment to pay my water bill.  But if your water bill is anything like mine, you know that \$100 is going to go up–i.e. it is subject to inflation.  I can still lend you the \$1200 you need, but now I need \$120/month.  Now you’re paying higher interest due to inflation.  Apply this phenomenon on average across a wide variety of products, slap a standardized measurement on the whole thing and suddenly you have a way to calculate the inflationary impact on bond prices/yields.  Simply put, if I know that “stuff that costs \$100/month right now” is going to cost \$120 in the near future, I’m going to price your loan accordingly.  I’m going to want payments of \$120/month for your 1-year, \$1200 loan (i.e. you’ll be paying \$20/month in interest instead of \$0 in the inflation-free environment).

Those metrics that we can slap on a wide variety of products include things like the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE).  When we take something like PCE and ignore food and energy, we’re left with “Core PCE,” and that’s the inflation metric the Fed has in mind when they talk about their symmetric 2.0% target.  Excess demand for “stuff” can result in “demand pull” inflation.  In other words, if people in my area want more and more water, the local water district may have to charge more to facilitate that. This is one reason that my ‘consumer-level inflation’ could rise.

On the other side of the supply/demand equation, there’s producer/wholesale level inflation.  Let’s say my water district runs into increased costs on their end, regardless of the level of consumer demand.  If they have to raise prices because of that, it’s known as “supply push” inflation.  Today’s Producer Price Index (PPI) is the most ubiquitous example of a wholesale inflation metric.

Does Producer-Level Inflation Even Matter?

It really depends.  Do people have the money to pay more for the thing that’s getting more expensive?  Will they willingly pay it?  Do they have alternatives?  Will the producers go out of business if they’re forced to eat the cost increases?  What really matters at the end of the day is whether consumers are actually paying the higher prices.  In that sense, PPI hasn’t ever been in the same league of market movement as the other inflation metrics.  Moreover, other inflation metrics haven’t had the same market moving capability that they had in decades past.  The entire relationship between our current inflation metrics and economic reality is actively being redefined, as evidenced by the Fed’s recent re-work of its inflation framework.  Things like the global pandemic only complicate the matter.

Producer-level prices SHOULD be rising (because economic activity was so crushed by the initial market reaction to lockdowns/etc. that a bounce back was inevitable).  As such, isolated instances of higher-than-expected inflation are no big deal.  Even when inflation levels off, producer prices are only ever gradually building a case for a change in consumer-level prices.  Considering we’d need months and months of excess consumer-level inflation to cause a shift in Fed policy or a constriction of economic output, today’s producer price data is very far down the line of potential market movers.  The bottom line is that it would take a sustained trend of higher inflation that translates to consumers and the economy before markets were eager to respond in the same way as they do to–say–a report like NFP or ISM PMIs.

Trends We’re Watching

Pretty simple stuff at the moment…  10yr yields had broken up and out of their prevailing narrow trend last week.  They made a big move back toward it yesterday, and are cautiously tiptoeing back into it today.  It’s not a firm re-entry just yet, so we’re not banking on it just yet.  The better takeaway would be to view last week’s support as a vote in favor of the .79% technical level as a near-term ceiling to watch in the event bond market weakness returns in the next week or two.  Any meaningful move back into the previous range is just a bonus at that point.

By Matthew Graham , dated 2020-10-14 10:52:54