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Rising real interest rates and falling non-energy commodity prices are laying the foundation for lower overall inflation. Meanwhile, there are encouraging signs of improving economic growth conditions.
Chart #1
Chart #1 is all about interest rates and inflation expectations. Interest rates have been rising of late, but not because inflation is rising. We know this because real interest rates have risen much more than nominal rates in the past several months. The top (white) line shows the nominal yield on 5-yr Treasuries, while the orange line shows the real yield on 5-yr TIPS. The line at the bottom of the chart is the difference between the two, which is the market's expectation of what the CPI will average over the next 5 years.
Inflation expectations reached a peak in mid-March of this year, boosted by sharply higher oil prices, which in turn were a by-product of the Iran conflict. Those expectations were (briefly) validated by the March, April and May CPI releases. But inflation fundamentals are already reversing for the better.
Chart #2
Chart #2 shows the price of gold (white line) and non-energy commodity prices (orange line). Both were rising smartly from September '25 through February of this year, even as measured inflation and inflation expectations remained muted. I'll admit to worrying last year that rising gold prices were throwing shade on my low-inflation predictions. Gold, as everyone knows, has throughout history been a refuge from inflation and economic and political risk. I didn't see either, thinking gold was simply getting carried away by momentum dynamics. Now, however, it turns out that gold was prescient: tensions in the Middle East were heating up and boiled over at the beginning of March.
The other side of this story, though, started playing out in late March as gold prices dropped, followed a month or so later by falling non-energy commodity prices. Gold and non-energy commodity prices may well be telling us that Middle East tensions are declining and—thanks to higher real interest rates which have effectively tightened monetary conditions—we are soon likely to see falling inflation. And perhaps, as Charts #4 and 5 suggest, an improving economic outlook. Who needs gold, now that the war is winding down. (Buy at the sound of cannon, sell at the sound of bells.)
Chart #3
Chart #3 reinforces a more optimistic outlook. As the chart shows, real interest rates (orange line, 5-yr real rates on TIPS bonds) have a strong tendency to strengthen or weaken the dollar (white line). Higher real rates simply make a currency more attractive to own and less attractive to borrow. The recent rise in real rates suggests that the dollar is likely to strengthen. A stronger dollar, in turn, would reinforce a lower inflation outlook because a strong dollar is symptomatic of strong demand for money. And with the M2 money supply growing at a modest rate, strong dollar demand means an effective shortage of money that might otherwise fuel rising prices.
Chart #4
Chart #4 shows the ISM manufacturing indices for the US and Europe. Both have risen of late, strongly suggesting improving conditions in the manufacturing sectors.
Chart #5
Last week's release of the May jobs statistics lends further support to the strengthening economy thesis. Jobs growth appears to have turned the corner for the better. It's still very weak, of course, but things are improving on the margin and that is the most important fact.
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As an aside, we are in Argentina right now visiting friends and relatives. The macro fundamentals, as I see them—lots of foreign investments inflows, rising central bank reserves, and a stable currency (the peso has actually strengthened meaningfully since I was last here two years ago)—suggest the economy is very likely to improve in the months and years ahead. Yet people are terribly frustrated, as they are in the US as well. Change is always painful at first.
More on Argentina to come.
