The top market news this morning is that the U.S. economy slowed more than expected in the first quarter of this year, but at the same time PCE inflation increased more than expected. Normally a slowing economy results in less inflationary pressures.
The first quarter GDP initial estimate came out showing a 1.6% growth rate, below the market’s prediction of a 2.4% number and a clear drop from the fourth quarter GDP growth rate of 3.4%. Also, this morning the quarterly rate of Core PCE inflation came out at 3.7% for the first quarter, which was above the market’s prediction of a 3.4% number and a material increase over the 2.0% for the fourth quarter of last year.
Today’s reports showing inflation increasing at the same time the economy is slowing, have increased worries about “stagflation” which is when economies are stagnant, yet inflation rates continue to increase. Today’s reports on the first quarter of this year will make tomorrow’s PCE report more important, since it will show April data and will give the markets an indication of what the inflation rate will look like for the second quarter of this year.
The net impact of these two reports this morning is increased worries about stagflation, which would be the Fed’s nightmare scenario, and how this increased risk will likely drive the Fed to keep rates higher for longer. As a result, bond yields jumped up this morning, and bond prices declined. As of this writing, the yield on the 10-year Treasury bond is 4.712% which is about seven basis points higher than yesterday morning, and MBS prices are presently about 44 basis points worse than yesterday. Usually, daily MBS price changes have a 1:1 impact to changes in daily mortgage lender rate sheets, based upon the price changes associated with each MBS coupon that correlates to each different mortgage interest rate on a lenders rate sheet. Different MBS coupons do not always move up and down the same amount each day, which is why some note rates have different daily price changes.
The weekly report showing new unemployment claims came out this morning showing 207,000 new claims filed last week, which was below the market’s prediction of a 215,000 number and a decrease from the prior week’s 212,000 number. This is a relatively low weekly number, and this suggests the labor market remains tight, which could be an additional inflationary pressure if employers need to increase wages in order to hire new workers.
Below is the current graph of the yield on the 10-year Treasury bond showing its yield over the last five trading days.
Stagflation? The Fed has been hoping that their rapid increase in the Fed Funds rate from zero to 5.25% would apply the brakes to the economy and would slow GDP growth rates. The Fed believes an annualized rate of about 1.8% GDP growth is the perfect number for an economy to grow and not have its growth create inflationary pressures. In the third quarter of last year GDP was 4.9%, and it dropped to 3.4% in the fourth quarter and today’s report is showing the continued drop to 1.6% in the first quarter of the year. So, GDP is moving pretty much as the Fed has hoped, and today’s GDP report, in isolation, would have been good news for the Fed, confirming that their strategy is working to bring GDP down to a level where it is not driving inflationary pressures.
If today’s GDP report came out at its 1.6% number this morning, and the if the Core PCE inflation rate would have come out at 3.4% or lower, we would likely have seen a price rally today in the MBS markets and a decline in the 10-year Treasury yield.
The pessimist’s view of today’s reports would be that inflation rates were rising at the same time the economy was cooling and this could lead to stagflation which is a worst case scenario for our economy. Businesses and consumers both suffer in a stagflation economy.
The optimist’s view of today’s report is that there is good news with the economy slowing down to hit the Fed’s intended GDP target of about 1.8%, and if inflation rates do not spike up in the second quarter of this year, then the Fed could be on track to hitting their targets and will then be more likely to do rate cuts. The optimists are hoping that as consumers spend the last of the remaining extra dollars they received during COVID, that monthly spending will normalize, and this will help slow down inflation rates. Consumer spending is not the only cause of inflation, state and Federal government spending also drives inflation pressures.
This pessimist versus optimist debate is why tomorrow’s PCE Core inflation report for April will be very important to the markets given today’s reports. If tomorrow’s annual Core PCE inflation report comes out at 2.7% or lower, this will tell the markets that inflation is trending down from the first quarter’s 3.4% number. The monthly increase in Core PCE from March to April will be the most important part of tomorrow’s report, because it will show the future trendline. The markets are currently predicting it will show a 0.3% increase in Core PCE prices from March to April which would annualize to a 3.6% rate. (12 X 0.3%). This would be flat to the prior February to March increase or 0.3%.
If tomorrow’s report comes out at 0.2% or lower, this would be very welcome news to the bond markets as this would annualize at a 2.4% rate and this would indicate that the second quarter is so far continuing the downward trend on inflation. If this happens, we would likely have a price rally tomorrow. However, if this report comes out at 0.4% or higher, it would signal the markets that it appears inflation rates are accelerating, despite a slowing economy. If this happens, we would likely have a sharp market sell off tomorrow with MBS prices worsening and Treasury bond yields increasing.
Tomorrow’s Reports. The Personal Consumption Expenditures (PCE) inflation report for March will be released with the markets predicting that he Core PCE inflation report will show a 0.3% monthly increase in prices, the same as the prior report’s monthly increase, and the annualized rate of Core PCE inflation will be 2.7% as of March, down from the 2.8% in February. The Fed’s public goal is to have Core PCE inflation decline to 2.00% and the Fed has been very public that they need to see this monthly report clearly trending in this direction before they will do any rate cuts.
Also, tomorrow we will see the University of Michigan Consumer Sentiment survey for April, with the markets predicting an index of 77.9, flat to the prior month. Given that consumer spending drives about 2/3rds of the economy, any surprise changes in sentiment could be a forward looking indicator of future consumer activity. Given today’s surprise reports, the markets will be more focused on the direction of tomorrow’s PCE report, but any surprise in this consumer survey could add fuel to the fire if there is a surprise in tomorrow’s PCE report. Tomorrow could be a volatile price day in the MBS markets as bond investors debate the merits of the pessimist and optimist outlooks for the future rates of inflation.
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