By Scott McIntyre
Co-Head of Investment Management
HilltopSecurities Asset Management

Unexpected cooling of the Fed’s preferred inflation measure and a surprisingly dovish comment from a prominent FOMC member, combined to reduce the likelihood of a pre-election rate hike this morning. The futures market is currently indicating a 34% probability of a quarter point increase at the next FOMC meeting on October 28, down from 70% on Monday. Unfortunately for bond investors, the rally was limited to the short end of the curve. The beatings continue on the long end.

The August Personal Consumption Expenditures (PCE) report reflected a change in methodology by the Bureau of Economic Analysis (BEA) resulting in a series of adjustments, but the magnitude of the downward revisions exceeded what economists were expecting. Core PCE was up just +0.2% for August, while July’s increase was lowered to +0.1%. On a year-over-year basis in August, the core rate was +3.0%, comfortably below the +3.3% median forecast. More importantly, the 3-month annualized core PCE pace was just +1.6%.

This appears to be an indication that energy prices may not be seeping into core inflation to the degree analysts had expected, although this report is admittedly an outlier. It’s also stale relative to other price measures. However, it does question how aggressively the Fed might need to tighten policy going forward, supporting a near-term policy pause.

In a speech yesterday, New York Fed President John Willams said another rate increase might be appropriate “late this year,” but acknowledged “no need for urgency” after the quarter point move in September. As head of the New York Fed, Williams is a regular FOMC voter and influential committee member, assumed to carry considerable weight.

However, indications of improved economic growth won’t help the hold-steady case as stronger demand typically puts upward pressure on prices, and a significant upward revision to second quarter GDP this morning is raising eyebrows. The final measure of Q2 GDP boosted the QoQ annualized growth rate from +1.5% to +2.2%. It’s rare to see such a big final revision, especially when the median forecast had called for an unchanged reading. The primary driver was considerably stronger consumer spending. Stronger growth and an unfortunate rise in crude oil prices this morning probably account for much of the bond market sell-off.

The steady rise in bond yields is a concern as even yesterday’s retreating crude prices didn’t stop the long bond from bleeding. Yesterday, the 30-year Treasury yield rose to its highest level since June 2002. This morning, it got worse. Elevated inflation expectations are playing a role, along with strengthening GDP growth and a surge in debt issuance, but a more pressing concern may be that U.S. political leaders are doing little to address the nation’s deteriorating fiscal condition. Investors are simply demanding a bigger risk premium.

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