Rising inflation feeds the bond bears

Core consumer prices posted an unexpectedly strong increase in April: The Consumer Price Index less food and energy rose at a 0.3 percent month-over-month rate, driven largely by a rebound in health care costs, which rose at a 0.7 percent monthly rate. Housing cost inflation remained steady as well.

The result is the highest core inflation increase since January 2013 and pushes its annual rate to 1.8 percent -- near the Federal Reserve's general 2 percent inflation target. It was the fourth consecutive increase in the annual rate. The three-month annualized rate of core inflation surged to a four-year high of 2.6 percent.

Headline measures (including food and fuel), however, were soft on lower energy prices, rising only 0.1 percent in April.

The report pushed stocks mostly lower on Friday as traders worry the report will bolster the hawks at the Fed and bring forward the timing of a potential interest rate hike this year. The futures market doesn't expect action until September at the earliest, but some Fed officials continue to talk up the chances of a hike in June.

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Moreover, projected interest rate paths have diverged sharply: The Fed has a much more optimistic and aggressive estimate of how fast rates will rise over the next two years. So, if inflation pressures keep building, the market will be forced to reevaluate its projections.

And as we've seen over the past month, when the bond market prices in higher inflation, bond prices suffer and yields rise. From a low of 1.8 percent in mid-April, the 10-year Treasury yield tested a high of 2.28 percent earlier this month as bond traders prepared for higher inflation. Their moves proved prescient, given the hot CPI inflation report.

While long-term Treasury bonds, represented by the iShares Barclays 20+ Year Treasury Bond Fund (TLT), have stabilized in recent weeks, additional increases in the inflation rate later this year will further weigh on prices and push up yields. This looks likely, given that the consensus of Wall Street economists expects GDP growth to rev up in the second half compared to softness seen in the first quarter.

Paul Ashworth at Capital Economics told clients the data "leaves the Fed with less scope to delay raising rates until it sees more evidence of a rebound in real activity." While Ashworth believes September is the date for rate liftoff -- the first increase in short-term interest rates since 2006 -- he wonders if the Fed would be forced to act in July if we get another couple of robust rises in the core CPI in May and June.

If so, watch long-term Treasury yields for clues that bond bears are pricing this in.

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.