Fed's Rate Cut Dilemma Amid Rising Inflation Risks

By Barry Stearns

7/11, 04:07 EDT

Inflation's Grip on the Yield Curve

Inflationary Pressures and the Yield Curve

The yield curve, a critical barometer for economic health, has been a challenging trade for many investors, often referred to as a "widow maker." Despite recent steepening, inflationary pressures, particularly from China, are poised to limit the Federal Reserve's ability to cut interest rates, potentially reversing the curve's trajectory.

  • Current Steepening: Leading indicators suggest more steepening in the yield curve over the next few months. However, the trend is expected to be short-lived due to rising inflation.
  • Inflation from China: Containerized freight prices in Shanghai have surged nearly 300% annually, leading China's Producer Price Index (PPI) by about three months. This rise in PPI is a precursor to global inflation pressures, including in the US.
  • US Inflation: The US Consumer Price Index (CPI) is expected to pick up, driven by sticky profit margins and rising primary-services components in the PPI report. The median primary services across over 100 industries have stopped falling and are now rising again.

Fed's Dilemma and Market Implications

The Federal Reserve faces a complex situation. While it aims to cut rates, persistent inflation, especially from external sources like China, may force it to reconsider.

  • Fed's Constraints: The Fed's ability to cut rates is limited by rising inflation. Fed Chair Jerome Powell's recent testimony to the Senate Banking Committee highlighted the Fed's cautious stance on easing aggressively.
  • Global Comparisons: The European Central Bank (ECB) managed a rate cut in June but is in no hurry for another. Similarly, the US yield curve has steepened and then flattened, with the 2s10s curve never steepening aggressively while still inverted.
  • Recession Risks: The market is increasingly pricing in the tail risk of a recession more than a re-increase in inflation, which would typically favor a steeper yield curve. However, this may be overly optimistic given the current inflation dynamics.

A Thought

The persistent inflationary pressures, particularly from China, suggest that the yield curve's recent steepening may be fleeting. Investors should be cautious, as the Fed's limited ability to cut rates could mean that the yield curve remains a challenging trade. The market's focus on recession risks over inflation may need to be recalibrated in light of these global inflationary trends.