Why the Bond Market May Be Underpricing the Next Inflation Shock

Sam (0:00)

Joining us at the desk is Ben Emons, CIO, Founder, FedWatch Advisors. Ben, thank you so much for your time. Happy Friday. Good morning.

Ben Emons (0:06)

Happy Friday, yes.

Sam (0:07)

We got through another busy week.

Obviously, we had a lot of Fed talk. It's been interesting that we had the FOMC minutes. We felt a bit stale, but we've had all the other noise in the background, which gives us some clues that, okay, they think that obviously another hike is in the works, but flexibility around the October meeting, is that the impression that you're getting?

Ben Emons (0:29)

Yeah, that's been in the market a little bit already, and I think what's happened is that they do this hike, then they get back into this deliberation about what the next steps really should be. That was in the minutes, but I know there was everybody had different reasons why they voted for a hike. Some people would not necessarily vote for the same reason. Neutral rate or energy prices, or was the AI build out of different reasons why they feel that all of this coming together leads to inflationary pressure on top of already where this inflation is above the target, that they need to react to that. Now, good or bad, the market has said like, wow, this is probably going to be more than just one hike.

I think what happened, yields going up, aside from hyperscale issuance and GDP being stronger, at least good data out there. I think there's an assessment that the market is feeling that this path has to stretch further from here, well into 27 to actually achieve that objective of getting inflation down.

That will be a tall order because the complexity of the whole Strait of Hormuz only is getting increasing by the day, and we have actually no idea how the conflict will end. I think it's a final point in the minutes, and also by Waller and a couple of others, they have now tied the duration of the conflict to their outlook for rates. I think that's really interesting to watch because if that stays uncertain, they will react to the uncertainty of the Strait of Hormuz with more rate hikes.

Sam (1:59)

Right. So it's down to now the cadence potentially of the rate hikes and the path moving forward. That they can perhaps, I guess, be patient with watching the data come in as long as this war continues, right? I mean, how are you looking at also some of the heat coming through, by the way, of prices in these PMIs? Because obviously there's going to be some sort of transmission that we start to see, but it could take a few months.

Ben Emons (2:25)

Right. And I think what you want to look at that is that PMI has a big input on PPI, therefore also on CPI.

And then there's the supply chain itself that's under pressure. So the New York Fed puts an index out on that. That showed an upward trend again. And I was looking at that today, thinking about the oil markets too, of how you have futures prices that people use for hedging. But the physical prices are again, rising much more like a gap between physical futures of almost $40.

That's also reflecting that PMI prices paid components and then into PPI. So combine and take that all together, it's like this pressures building in the system of the shock from closing the strait and the strait remaining close. And I think that's what this Fed is struggling with. If this continues, then they're gonna have to get more far more restrictive than what they are envisioning now. Like a kind of a shallow path will become a bigger path. And that's where the chance will be for markets if that comes out.

Sam (3:27)

Right, because the numbers that we're seeing on the screen, as far as some of the futures prices, I mean, those that are buying the stuff right now to turn it into the refined products are paying a lot higher price. And obviously, we're looking at on our charts currently. Is that what you're getting at? And that why you're saying there's a greater correlation between yields right now and the crack spreads, which are much higher?

Ben Emons (3:48)

Yeah, that's one way to think of it. And actually, the correlation between yields and the physical price, the data brand, as they say, the physical price of oil is very strong, since June, just one straight line.

Sam (3:59)

Right.

Ben Emons (4:00)

And what that tells me is that, that's different by the way, Sam, I haven't seen this dynamic in the past. Yields are more driven by other reasons, supply and GDP or whatever, or Fatspeak. But I think what's going on is that people are looking at this conflict saying, like, aside from we don't know how it will end, the disruption that's taking place will become bigger and bigger. It's going to rise at some point. And does this mean that inflation everywhere is going to rise with an acceleration into 2027?