Thoughts On ... One Small Step for the Bond Market

February 21, 2023 | Matt Barasch


The U.S. economy continues to send out mixed signals, which is beginning to prove challenging for markets. This week we had a slew of economic data headlined by another inflation gauge – the Producer Price Index (PPI). Unlike CPI (the Consumer Price Index), which measures the change in prices experienced by consumers of final goods - a chicken dinner at Swiss Chalet, gasoline at the pump, a Bob Dylan Live at Toad’s Place tee shirt - PPI measures the change in prices of intermediate goods – the change in cost that Swiss Chalet paid for the raw chicken from one month to the next.

Now, it’s important to note that changes in PPI do not necessarily lead to changes in CPI. Producers can and often will absorb price increases, which means lower margins, either to stay competitive (they are worried that their peers will not raise prices) or because they see the change as temporary. Similarly, they will often be slow to pass on price declines because they are trying to squeeze a bit more profitability out of the quarter. Slow responses will tend to be the case with items where changing the price on the regular is cumbersome – Swiss Chalet is probably not going to raise prices on the menu because chicken prices happened to spike for one month – whereas commodities – eggs in the grocery store for example – will see their prices change regularly as a slow response would likely lead to costumers quickly switching grocery stores to find the cheaper eggs.

Anyway, back to last month’s PPI, which rattled markets with its release this week, which comes in the wake of a higher than expected CPI reading. Let’s look at a chart and then comment:

As you can see, both PPI and CPI had been trending lower for a period of 6-months (7/22 to 12/22), but both saw unwanted spikes in January. And while PPI continues to run hotter than CPI (throwing some water on the fire of those who argue price gouging is behind the rise in consumer prices), they both are at levels that will not support the U.S. Federal Reserve ending its interest rate hiking cycle (let alone cutting rates) any time soon.

Market Update

In a sense, 2023 will all be about the market trying to gauge: 1) when the Fed will be done; and 2) when the Fed might begin to cut rates again.

Two weeks ago, the market had a view that the Fed would be done by April and cuts would be coming by year end. Both Canadian and U.S. markets were lower over the past two weeks, while the Canadian dollar, which had rallied nicely in January, has also begun to sag.

Post PPI and CPI (not to mention continued hot job numbers), bond markets went from pricing in an end to Fed rate hikes by April and the potential for rate cuts by year end to pricing in an additional Fed rate hike in June, which would bring the overnight rate to 5.375%, and no rate cuts until the first half of 2024.

We tend to think that where the bond market is now is likely close to the most extreme we will see. In other words, we doubt the Fed goes much beyond 5.375% and while we were extremely skeptical the Fed would cut rates in 2023 (one of the main reasons we were cautious on the year), we are also equally skeptical that rate cuts will not be forthcoming in the first half of 2024.

We don’t think equity markets have fully priced in the above as of yet, so our caution remains. However, getting the bond market in the right place was an important first step. The giant leap for the equity market will come later.