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The PCE is Increasing Perhaps Shattering Market Compliance

The Federal Reserve’s preferred inflation gauges unexpectedly accelerated in January. Consumer spending surged after a year end slump.

The personal Consumption expenditures Price Index (PCE) rose 5.4% from a year earlier and the core metric was up 4.7%, both marking pickups after several months of declines.  The monthly increase of 0.6% was the most since June.  The core index also climbed 0.6%.

The data further underscores persistently high inflation.  A pullback in inflation at the end of last year has proved to be more of a mirage after revisions and the latest figures.  Moreover, the exceptional strength of the labor market remains a key hurdle for the Fed to reach their 2% goal.

Additionally personal spending jumped 1.1%, the largest advance since March 2021 following weakness at the end of last year.

Because of the data, the yield on the benchmark two-year Treasury note surged to its highest level since 2007.  Yields on Treasuries with maturities from 2-7 years also rose on the emerging belief that rates will be held at a higher rate for a longer period than the market had expected.

Writing it differently, the market is further accepting the Federal Reserve’s version of tomorrow’s reality: the version that they have been telegraphing for at least six months.

The next question is whether longer dated Treasuries will begin to discount an inflation rate greater than the 2% speed limit?  At this juncture, long-dated Treasuries have confidence the Fed will vanquish inflation.

Bond legend Mohamed El-Erian commented yesterday “the market is now beginning to doubt whether the Fed can deliver the 2.0%.”  El-Erian further remarked perhaps the new speed limit should be between 3% and 4% given “the tremendous pain that will be inflicted on the economy to achieve this 2% rate.”

Historically, longer-dated Treasuries trade about 250-300 bps over the prevailing inflation rate.  If the markets return to the norm and if inflation moderates only to 3%, longer dated Treasuries would hypothetically yield around 5.5% to 6%.

According Bloomberg analytics, if  the above occurs, longer dated treasuries would have a negative annual total return of 15.70%.

If the above scenario does materialize, there is a strong probability that the equity markets will also decline.

According to Bloomberg, last year was the worst performance on record for the popular 60/40 portfolio [60% stocks and 40% bonds], declining more than 20%. There has only been a “handful of times” that such a portfolio has declined during the last 50 years and never has there been back-to-back annual declines.

If inflationary expectations begin to become unanchored and if longer dated Treasuries trade in their historical fashion with inflation, there is a strong probability the popular 60/40 portfolio will again decline.

Both CNBC and Bloomberg have reported the typical 401K account at Vanguard and Fidelity declined by 22% in 2022.  The average 401K balance at Fidelity is about $103,900 and at Vanguard the average balance is $112,572.  The median balance is $22,354 and $27,376, respectively.

Finance 101 dictates inflation and interest rates are the primary determinate of valuations.

Unfortunately, many today are learning about this basic tenant; a tenant that has been ignored for many years in a zero-interest rate environment.

What will happen today?

The economic calendar is comprised of several top tier statistics including durable goods orders, several housing statistics and inventories, both ISM indices and sentiment survey.

Last night the foreign markets were mixed.  London was up 0.78%, Paris up 1.66% and Frankfurt up 1.55%.  China was down 0.28%, Japan down 0.11% and Hang Seng down 0.33%.

Futures are up about 0.50% on the belief the averages might be oversold.  The 10-year is off 3/32 to yield 3.96%.

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Kent Engelke

Chief Economic Strategist Managing Director

The views expressed herein are those of Kent Engelke and do not necessarily reflect those of Capitol Securities Management. Any opinions expressed are statements of judgment on this date and are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated or projected. Any future dividends, interest, yields and event dates listed may be subject to change. An investor cannot invest in an index, and its returns are not indicative of the performance of any specific investment. Past performance is not indicative of future results. This material is being provided for informational purposes only. Any information should not be deemed a recommendation to buy, hold or sell any security. Certain information has been obtained from third-party sources we consider reliable, but we do not guarantee that such information is accurate or complete. This report is not a complete description of the securities, markets, or developments referred to in this material and does not include all available data necessary for making an investment decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. If you would like to unsubscribe from this e-mail distribution, please reply to this e-mail and indicate that you wish to unsubscribe in your response.