Volatile oil prices have moved centre-stage again, after Israel’s attacks on Iran. Admittedly, Iran is less important to oil markets than Russia, and it is tempting to conclude markets will shrug aside the latest regional conflict. But tail risks cannot be ignored. Ironically, break-even inflation rates had continued to fall in the US last week. Real yields remain elevated. The CPI data has been benign, but the Federal budget deficit continues to run at close to $2.0tr a year, on an annual basis. For now, the prospect of inflation NOT accelerating this year, remains the biggest pull for Treasuries.
The core inflation rate, excluding shelter is still running below 2.0% following May’s print of 1.90% y/y. There is time for tariffs to feed through to the data and the durables inflation rate has nudged into positive territory (albeit just 0.01%) for the first time since November 2022. But as with any price ‘shock’, it will be interesting to see how far consumers resist attempts by retailers to pass on higher costs. Overall, non-financial profit margins in the US remain close to all-time highs. Margins are wide enough to absorb tariffs. In mitigation, the non-manufacturing ISM survey showed a rise in price pressures last month. But expectations are one thing: hard data is more reliable. There is also the small matter of the Immigration and Customs Enforcement sweeping up migrants who are gainfully employed, causing worker shortages and businesses to close.
All this puts Jay Powell in a bind. Quite rightly, he does not want to be seen bowing to Trump’s pressure to cut interest rates. The Fed chair might conclude, that so long as the US is creating jobs, it is possibly best to stand pat. But initial jobless claims are starting to drift higher. As the assassination of the Minnesota law maker and her husband shows, political risk is high. The fight for control over the California National Guard raises important constitutional issues. The war between Israel and Iran will split the Republican base, with many supporters wondering where the Trump ‘peace dividend’ has gone. Longer-term, real yields will start their upward march, but there may be better opportunities to be short of inflation-indexed Treasuries.
