We thought we were done with our recent stream on prices, consumer confidence, and their impact on bond yields, but the graph below and analysis from a client of ours is a great encore to the recent commentaries (LINK LINK). Our first commentary stated:
“While we understand the fear, the reality is that the market is not pricing in future inflation in line with the market reaction. The extra yield, known as the term premium, will likely normalize when oil prices fall and inflation expectations cool.”
We presume many people read it and asked, ‘when?’ To guide us, the graph and table show the three most pronounced surges in oil prices over the last 40 years. The momentum in the two prior surges was literally off the charts, as measured by the difference between the 50- and 200-day moving averages of oil prices. The moving average differential is shown in blue and red. Today, the 50-day moving average of crude oil is $27.01 above its 200-day moving average, the largest gap since 1984.
In 2022 and in 2008, the moving average divergence reversed drastically after peaking. As our client wrote:
You will notice that in both prior scenarios, we not only witnessed a dramatic pullback in the 50dma-200dma spread (eventually forming a Death Cross) but also saw a substantial decrease in prices.
It’s possible that tensions with Iran persist, and crude oil prices remain high. Such an outcome would allow the 200-day moving average to catch up to the 50-day moving average without a significant decline in oil prices. However, if this moving-average divergence peaks with a US-Iran agreement and oil flowing freely, the odds favor price declines more akin to those in 2022 and 2008. Given the strong correlation between oil prices and , the type of normalization could profoundly reduce CPI and, with it, sharply reduce bond yields.
A Tale Of Two Inflations
This morning, the Fed’s preferred gauge of inflation, the BEA’s PCE Price Index, showed that rose by 0.4% and by 0.2%. Both were 0.10% below expectations. The PCE is not overly concerning, but the recent CPI data is certainly painting a more cautious picture. Understanding the differences in the calculations is important to forecast how the Fed might react to inflation.
CPI and PCE measure inflation differently in three important ways.
- Basket composition. CPI measures what consumers actually pay. PCE captures a broader universe of spending, including healthcare costs paid by employers and the government on behalf of consumers. That single difference dilutes the weight of categories consumers feel most acutely.
- Energy weighting. CPI assigns roughly 7-8% weight to energy, with gasoline alone at 3.5%. PCE energy weight sits closer to 4-5%. When oil spikes, as it has during the Iranian conflict, CPI captures the full hit to the consumer while PCE tends to understate it.
- Substitution bias. PCE assumes consumers shift behavior when prices rise, such as buying less gas, switching brands, or trading down. CPI uses a fixed basket. Thus, in a high-inflation environment, PCE should always be lower than CPI.
The calculation tends to produce a gap of 30-50 basis points between the two measures in high-oil-price environments. While the Fed closely watches PCE, the bond market tends to react more to CPI headlines. That disconnect helps explain why yields may be pricing in more sustained inflation than the Fed’s own framework actually sees. The graph below shows that PCE has had less reaction to the recent oil spike than CPI and .
Tweet of the Day
