Rising inflation points to rising bond yields

In April the CPI registered a 3.2% rise over the past 12 months, a 5.1% annualized rise over the past six months, and a 6.2% annualized rise over the past 3 months. The bond market and the Fed appear to be ignoring that, in the belief that it is mainly due to energy prices, and those have already cooled in recent weeks, so perhaps this is only a transitory rise in inflation.

But as this chart shows, the core CPI (ex food & energy) is up 1.3% over the past 12 months. Moreover, it is up at an annualized rate of 1.8% in the past six months, and a 2.1% annualized rate in the past three months. It's not so easy to dismiss the recent rise in inflation as transitory. If we just look at the CPI ex-energy, it is up 1.6% in the past 12 months, and has risen at an annualized rate of 2.3% in the past six months and 2.9% in the past three months. Inflation is heating up, no matter how you slice and dice the numbers, and the pickup appears to be broad-based.

This chart also suggests that the bond market is on shaky ground, since inflation is the most important determinant of yields. The core CPI will almost certainly approach 2% on a year over year basis in coming months, and could well exceed that level before the year is out. The last time the core CPI was 2%, bond yields were substantially higher than they are today. The bond market is ignoring the rise in inflation for now, in the belief that economic weakness makes it only a temporary phenomenon, but that belief is going to be tested in coming months. From my perspective, I see no reason for core inflation to decline, so I think there is a good chance that Treasury yields are going to rise.

Full disclosure: I am long TBT at the time of this writing.

Dramatic improvement in commercial real estate

Real estate markets are still very depressed, of course, but they are doing a whole lot better than people expected just a year ago. That's the message of this chart, which plots the price of a basket of commercial real estate-backed securities rated AA and issued back in October '07. Last summer these securities were trading around 35 cents on the dollar, which meant that investors expected a massive wave of defaults to occur. Today they are trading at 63 cents on the dollar, which means that default expectations have collapsed relative to what they were last year. This improvement also means that banks, institutional investors and corporations who have held these securities and were forced to write them down in the wake of the crash because they were "impaired," have now realized substantial gains that have not yet flowed through to their balance sheets (they had to realize the loss when the securities were declared impaired, but they won't have to realize the gains until they are sold).

Retail sales look quite strong

Retail sales are growing strongly, up 7.6% in the past year, and up at 9.9% annualized rated over the past six months. Rising gasoline prices have contributed to this strong growth, of course, but even excluding autos and gasoline, sales are up at a 6.2% annualized pace in the past six months.

It's interesting therefore to compare the recent period of strong gasoline price rises with what happened to retail sales the last time we had a huge spike in oil and gasoline prices. The chart above does just that: the white line being retail sales, and the orange line oil prices. Note that in late 2007 and early 2008 retail sales hardly budged despite soaring oil prices, whereas over the past two years both oil prices and retail sales have soared. Things are certainly different this time around. The rise in retail sales of late owes its strength not only to higher prices, but also to more jobs, rising confidence, easy money, and a global recovery.