September CPI: A Blip or a Bounce?

September CPI put a halt to progress across several of the areas necessary to return inflation to 2 percent. Energy prices increased materially for the second consecutive month amid robust demand for oil and gas alongside supply cuts from OPEC. Despite volatile energy prices, no sustained shift in energy prices has materialized in response to the attack on Israel, although it certainly expands the distribution of outcomes for energy costs over the coming months. More concerning for inflation is the re-acceleration in both shelter and core services excluding shelter (supercore), which combined comprise most of core inflation and are cyclically sensitive categories. The increase in the former can be overlooked as there remains disinflation to come based on known shifts in private market rents; however, marginal rents on a real-time basis are stabilizing meaning the expiration date for disinflation from the housing market is visible.

The acceleration in supercore is more difficult to dismiss outright. The labor market continues to surprise with robust hiring, few jobless claims, and signs of easing relegated to the margin. The broad and rapid disinflation beyond supercore year-to-date lent credence to the FOMC’s initial contention that much of the post-pandemic inflation owed more to transitory factors rather than excess demand for labor. Stalling progress on supercore, however, could fuel concern that excess demand for labor requires more restrictive policy from the Fed. It is only a month of data, so we are not sounding the alarm, but we believe it is the most important indicator for near-term Fed policy expectations.

Moving To The Forest From The Trees

Before the CPI surprise, there had been a noticeable shift in FOMC participants’ messaging on the outlook for interest rates and the economy. The catalyst for the shift was the unceasing increase in longend Treasury yields throughout the third quarter. Policymakers noted that higher long-term interest rates, if sustained, reduce the need for further Fed action. The fact that short-term interest rates are within a hike of nearly all participants terminal rate helped, but the concerted shift in messaging is designed to refocus investors’ attention on financial conditions. Interest rate policy, asset purchases, emergency facilities are all designed and used to impact aggregate financial conditions, which comprise short- and long-term interest rates, equity prices, credit spreads, the U.S. dollar, etc. The transmission of policy changes to financial conditions are variable and context-dependent with feedback provided by the economy’s response.

The third quarter’s increase in yields, despite limited volatility in the 2023 policy path, stoked questions about implied growth, the credibility of the Fed’s higher-for-longer messaging, and whether risks associated with interest rate positions were rising for reasons beyond the Fed’s control. The net result was a tightening in financial conditions as higher interest rates, and risk premia, filtered out into riskier assets. In turn, the tightening allows FOMC members to loosen their hold on financial conditions solely through the near-term path and focus more on keeping interest rates elevated for some time. It also reminds investors that financial conditions are jointly determined by policymakers and markets.

Taking A Bite On Duration

As to pinning down the exact cause behind the increase in rates, our take is that policymakers believe much of it stems from higher risk premia. Why might investors demand more risk premia in bonds? Rising concern about fiscal issuance given large deficits and limited demand from both private and central banks is a popular explanation. However, deficit revisions over the quarter were not substantial nor was the Treasury’s decision to increase auction sizes to meet their needs surprising for those paying attention. Maybe more risk premium is necessary given concerns around inflation, this explanation also suffers from the fact that the increase in rates was mostly contained to increased real rates rather than inflation compensation. High interest rate volatility is another culprit, but the rapid change in risk happened over the previous quarters rather then recently.

From our vantage point, the fundamental arguments behind the third quarter’s increase in yield are unfulfilling as well. Growth expectations have increased as has the credibility of the Fed’s intention to refrain from cuts any time soon, but the magnitude of the rate increase is surprising under these assumptions. Plainly, for us, momentum is negative, and the asset class is not playing its traditional role in providing diversification for risk assets. Add to that a shift towards more price-sensitive buyers and the uncertainty associated with the business cycle, there are few willing to staunch the losses. However, we think adding to duration makes sense here. The selloff could increase the likelihood that the Fed hiking cycle is finished. Solving for a low level of risk premia in sovereign bonds requires expectations for very few rate cuts in the foreseeable future. While we continue to be suspect about the likelihood of a soft landing, we believe it does not require a recession for long-end bonds to deliver excess returns to the front-end from here.

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Important Information

The views expressed herein are those of Harbor Capital Advisors, Inc. investment professionals at the time the comments were made. They may not be reflective of their current opinions, are subject to change without prior notice, and should not be considered investment advice. The information provided in this presentation is for informational purposes only.

This material does not constitute investment advice and should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy.

Performance data shown represents past performance and is no guarantee of future results.

Investing entails risks and there can be no assurance that any investment will achieve profits or avoid incurring losses.

Harbor Capital Advisors, Inc.

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