RTX - December CPI A Touch Warm Rates Climb VGLT And The Fed In Focus

2024-01-11 10:45:51 ET

Summary

• December CPI came in slightly higher than expected, with headline inflation at +0.3% and core inflation at +0.3%.
• On a year-over-year basis, headline CPI is now +3.4% and core inflation is 3.9%.
• The CPI increase was driven by a 0.5% increase in shelter inflation, accounting for half of the overall increase.
• Equities dipped, rates rose, and the dollar ticked higher following the inflation data, and all eyes are now on the Fed and corporate earnings.
• I detail where long-term Treasury yields may drift in the months ahead.

December CPI came in slightly hotter than the consensus estimate. Headline inflation verified at +0.3%, which was warmer than expected, but the Core rate, which strips out the volatile food and energy components, matched forecasts of +0.3%. Shelter inflation was higher by 0.5% in December, accounting for half of the CPI increase.

On a year-over-year basis, Headline CPI is now +3.4%, which was above the +3.2% forecast. The Core inflation rate is now 3.9%, below 4% for the first time in two and a half years. Real average hourly earnings were up 0.8% in 2023 with real average weekly earnings higher by 0.5% over inflation. Along with the inflation report, continued sanguine Initial Jobless Claims hit the tape.

Overall, the 8:30 a.m. data released today resulted in a smaller chance of a March Fed rate cut. In the near term, no policy change is expected at the January FOMC meeting.

December CPI Verifies Hotter than Expectations

Headline CPI MoM and Core CPI MoM

CPI Categories

Largest Contributors to CPI's YoY Increase

WisdomTree's Alternative Inflation Barometers

Equities dipped in the moments after the CPI data crossed the wires while interest rates ticked higher modestly. The yield on the benchmark 10-year Treasury note (US10Y) jumped to 4.05% after hovering under 4% earlier in the morning. Given that Core CPE is now at its softest level since May of 2021, the disinflation bulls continue to look correct in their macro calls, but we must also consider that the final leg lower in order to get to the Fed's 2% inflation objective may be the toughest part of the tightening process.

CME FedWatch: A 34% Chance of A March Ease

Of course, last month it was revealed that Core PCI on a six-month annualized basis fell under 2% - that is a gauge the Fed looks at closely when it considers both its interest rate policy and open market operations regarding the size of its balance sheet. Some recent Fed Speak suggests they may taper their balance sheet runoff in the months ahead.

Bigger picture, financial conditions have loosened considerably over the past several months amid sharply rising stock prices and easing bond yields. A drop in the dollar and narrowing credit spreads have also resulted in more favorable borrowing conditions for small and large companies. A looser environment could result in inflation being a bit higher than what the Fed wants. So long as wage pressures keep on easing, then the Fed should get what it wants over the coming quarters, allowing for several interest rate cuts over the next 12 months.

As it stands, the market has priced in a total of 140 basis points in cuts this year, equating to between five and six quarter-point eases. Now, investors should remember that the Fed Funds futures market is a hedging arena, which means there is a natural downward bias to what future rates are suggested. So, I assert that three or four cuts are probable, not upwards of six.

A risk is what happens in the Red Sea with respect to energy prices. The price of WTI (CL1:COM) remains low in the low to mid-$70s, but any uptick in geopolitical jitters could lead to another Q2 rally in oil prices. What's more, the recent downward move in mortgage rates and a jump in borrowing demand could lead to higher housing costs. According to the BLS, "The shelter index increased 6.2 percent over the last year, accounting for over two-thirds of the total increase in all the items less food and energy index."

Following the warm December inflation numbers, long-term Treasury yields ticked up. I noticed that overall bond market volatility, graphed below, has turned a bit lower over recent days, even before Thursday's CPI report. Reduced Treasury volatility would be a welcome sign for corporate America, along with lower rates, of course.

My outlook? I see long-term yields treading water in the 4% to 4.5% range looking ahead. Thus, I have a hold rating on the Vanguard Long-Term Treasury Index Fund ETF Shares (VGLT). Consider that long-run inflation expectations are near 2.2% while real growth may average near 2% to 2.5% over the next handful of years, making for a fair long-term Treasury yield of 4.2% to 4.7% using those assumptions.

Interest Rate Volatility Ebbs

For background, VGLT seeks to provide a high and sustainable level of current income by Investing primarily in U.S. Treasury bonds. The fund maintains a dollar-weighted average maturity of 10 to 25 years on the yield curve, according to Vanguard .

The ETF sports a low 0.04% annual expense ratio while its share-price momentum is weak. I assert, however, that the long-term bond bulls have made significant progress regarding the chart situation, which I will detail later. VGLT currently yields about 4.2% based on its latest yield to maturity while liquidity on the ETF is high considering its 90-day average daily volume of more than 3 million shares and a very tight historical bid/ask spread. Seeking Alpha assigns a C- risk score as a result of high volatility at times in 2023.

Treasury Yields Tick Up to Start 2024

The Technical Take

Given the macro backdrop and a long-bond rate that I see as near appropriate given where expectations are settling, let's assess the technical picture in light of today's December CPI report. Notice in the chart below that VGLT broke under key support at the $57 mark just as the final quarter of 2023 got underway. Interest rates spiked to 5%, resulting in the price of this ETF falling to under $52. Following sanguine inflation trends and a more dovish Fed, Treasury rates retreated. That helped VGLT's technical situation, and $57 is now a key support spot once again. I see resistance just under $68.

Moreover, with a long-term 200-day moving average that is turning flat in its slope, the bears are losing their grip on the ETF's long-term trend. For now, VGLT is working off technical overbought conditions, and I expect further choppy price action before we get clues on where the fund may go later this year. If weaker economic data comes to pass, then VGLT would likely rally through $68, but if more hot inflation reports come down the pike, then VGLT investors should monitor $57 on the downside.

VGLT: Back in the Trading Range, Long-Term Trends Turning Sideways

The Bottom Line

The long bond has found its footing between 4% and 4.5%. I see some upside risk to yields given where inflation and growth forecasts are, but a technical trading range appears in full swing on VGLT. I do not see today's somewhat hawkish December CPI report changing the situation very much. All eyes now turn to the Fed later this month and corporate earnings season which kicks off with the big banks on Friday.

For further details see: