CPI Consequences
It is not as binary as payrolls, but the CPI release today could be consequential. If softer than expected, the Fed will gain more room to cut. Based on real-time CPI (Nowcast), the Fed Funds rate in real terms is 1.75 percent, and has nudged up marginally over the past weeks as gasoline and grocery prices remain in check.
The range of estimates is tight (2.7% to 3.0%), so any surprise to the downside would push up the Funds rate accounted for CPI, which is the de facto “room” for the Fed to cut the (nominal) rate. By my estimate, the Fed is restrictive by 50 basis points after adjusting for inflation, and that may increase somewhat after this morning’s release.
The market is pricing CPI at 2.9% and expects the headline to rise by 3.3% by December (see Figure 1). The releases are before every FOMC meeting (except in December), so the market is pricing that Fed policy becomes less restrictive if it were to keep rates unchanged.
However, the economy continues to exert price pressure. Although CPI has a lower tariff pass-through rate (estimated at 10% to 30% in about 20% of the index) compared to PPI, energy may not sufficiently offset the stickiness of services caused by leisure categories.
It will not derail a rate cut next week, and in fact embolden the discussion where, in my view, 50 basis points is on the table because tariff pass-through is moderating (for now) against a rapidly weakening labor market health.
Figure 1: CPI pricing until year-end (Y/Y%)
Source: DTCC, CME, BLS
A consequence of the Fed’s strategy of cutting rates to handicap the unemployment rate and bet on the inflation rate to top out should lead to negative real interest rates. The market is pricing the funds rate below 3 percent in a year from now, while the expectation for inflation remains above 3 percent (Figure 2).
If it were up to the president, the real interest rate would be a negative 2 percent. Still, the fact that markets are moderately on board with Trump’s view by pricing a negative 0.5% real interest rate in a year from today could present a significant underpinning of lofty equity valuations and provide a buy signal for bonds.
Figure 2: Negative real interest rates in a year from today (%)
Source: CME
To that point, sentiment about bonds remains in euphoria according to the late Tobias Levkovich methodology. Based on his panic/euphoria model for stocks, I constructed the same indicator for bonds using similar variables (see legend below Figure 3).
The concept of bond euphoria is about yields that remain high by recent historical standards. There remains a risk that yields could rise further, given the 30Y yield has broken the technical wedge of lower highs and higher lows since 2024. Nevertheless, inflation risk, although it is underpriced in the long term, presents tactical opportunities in bonds in the near term.
A softer CPI, which could be dragged down too by energy prices like in PPI, should, at the margin, deflate some of the term premium, which of late has been correlated with oil prices. If CPI comes out below 2.7, the Levkovich euphoria could trigger a further rally in yields.
Figure 3: Levkovich Panic/Euphoria for Bonds
Source: Citigroup. Panic/Euphoria indicators include MOVE, CFTC positioning, ICI fund flows, inflation break-evens, spreads, short interest ratio, 10Y put-call ratio, liquidity indices, repo, and volumes.