The Fluctuating Market Has Investors Guessing

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 |  Includes: SPY, TIP
by: James Picerno

Wednesday's news about the strong jump in retail sales cheered equity investors, and for good reason. The 1.4% gain in consumer spending in May is the highest in 16 months. But in keeping with the spirit of the times, for every bit of good news, there lurks a new reason to worry.

Wednesday's news on import prices, for instance, surprised on the upside, coming in at 0.9% last month, which was much higher than the consensus forecast.

Meanwhile, Thursday morning's producer price report for May offers another indication that pricing pressure may be staging a comeback in the wholesale world. The seasonally adjusted PPI advanced by 0.9% last month, up from 0.7% in April. On an annual basis, PPI rose by 3.9%. As our chart below shows, it's clear that there's inflationary pressures, while not necessarily fatal, remain a concern.

Looking Up

The optimistic view is that after stripping out food and energy, the PPI still looks tame. Yes, and no. It's true that the core PPI rose just 1.6% for the 12 months through May, which is less than half the pace for the top-line number. But, the annual rate of 1.6% is unchanged from April. In fact, the annual rate of change in the core PPI has been holding fairly steady in a range of 1.6% to 1.8% this year. The question is: will the core rate be pulled up if the top-line pace continues to take flight? Looking beyond the PPI one may wonder what's in store for consumer prices, which have been showing signs of trending higher too. The May CPI report was due to be released on Thursday.

Meanwhile, supporting evidence for thinking that inflation remains an issue comes from the bond market, which has been signaling its displeasure with the matter of prices. Although the
yield on the benchmark 10-year Treasury turned down on Wednesday, it's too early to declare that the month-long surge in interest rates has run its course.

But if all the inflation talk has convinced the fixed-income set to reconsider the future, there's still no sign of fear in the trading of Fed funds futures. In this corner of financial forecasting, calm prevails in second guessing the central bank's next move on interest rates. Contracts through next March remain priced in expectation that there's no change in store for the current 5.25% Fed funds rate.

Perhaps. But while we ponder the embedded message in futures pricing, it's getting harder to ignore the opportunity bubbling in the market for inflation-indexed Treasuries. The surge in long yields has spilled over into the TIPS market, with the 10-year inflation-indexed Treasury yield closing at 2.75% on Wednesday. Tuesday's close of 2.83% is the highest since at least 2003 (the Treasury site's data doesn't go back any further). It's still not a no-brainer for locking in a real yield just below 3%, but it's getting close.

Ours is still an economy of conflicting signals and data that burns hot and cold, depending on when and where you look. But while the jury's still out and the market's lie in perpetual fear that the other shoe may drop, the prospect of locking in real yields north of 3% for the next decade strikes us as eminently reasonable for a portion of assets. As such, mark us as officially on a TIPS watch. We don't know if we'll be able to buy above 3%, but we're prepared to open the door when, and if Mr. Market knocks.