U.S. PCE deflator report could influence Fed’s decision on whether inflation weakness is transitory
Inflation expectations rise mainly due to higher crude oil prices
U.S. personal income and spending expected to be mixed
U.S. ISM manufacturing index expected to remain strong
U.S. vehicle sales expected to show a mild rebound from 2-3/4 year low
U.S. PCE deflator report could influence Fed’s decision on whether inflation weakness is transitory — The markets will be closely watching today’s PCE deflator report for a further assessment of whether the recent softness in the inflation statistics is simply transitory (e.g., from the recent drop in prices for cell phone service and prescription drugs) or whether it is being caused by more fundamental deflationary forces. The PCE deflator is the Fed’s preferred inflation measure, which means that today’s report is more important than the CPI or PPI reports.
If the softness in inflation persists, then the Fed may have to forego its plan for one more rate hike this year, likely in December. Some Fed officials have already gone so far as to say that they will not favor another rate hike until inflation stabilizes and shows signs of moving back up towards the Fed’s +2.0% inflation target. The market is currently discounting the odds at 54% for a Fed rate hike by December.
The market consensus is for today’s June PCE deflator to ease slightly to +1.3% y/y from May’s +1.4%, while the June core PCE deflator is expected to be unchanged from May’s +1.4% y/y. The expected June headline PCE deflator of +1.3% would be down substantially from February’s 5-year high of +2.1%. The expected June core PCE deflator of +1.3% would be down substantially from the 5-year high of +1.8% seen earlier this year in Jan-Feb.
In any case, today’s expected PCE deflator report of +1.3% for both the headline and core figures would leave inflation well below the Fed’s +2.0% target.
Inflation expectations rise mainly due to higher crude oil prices — While the inflation statistics have recently been weak, market expectations for inflation have risen substantially over the past month, mainly because of the upward rebound in oil prices. Sep WTI crude oil prices have rallied by a total of +18% over the past 5 weeks and posted a 2-month high of $50.41 on Monday. During that same time frame, the 10-year breakeven rate has risen by about +15 bp to the current level of 1.82%. The nearby charts illustrate the fairly strong correlation between crude oil prices and the breakeven inflation expectation rates.
The recent rise in inflation expectations means the Fed will be a little less nervous about the inflation outlook, meaning a higher likelihood of Fed rate hikes. The rise in 10-year inflation expectations has also put some upward pressure on T-note yields. Since June 26, the 10-year breakeven rate has risen by +10.0 bp while the 10-year T-note yield has risen by a larger +15.4 bp. The 10-year T-note yield was pushed higher over that time frame, not only by higher U.S. inflation expectations, but also by the sharp rise in German bund yields that followed ECB President Draghi’s hawkish speech in Sintra, Portugal on June 27.
U.S. personal income and spending expected to be mixed — The consensus is for a strong June personal income report today of +0.4%, matching May’s report of +0.4%. However, the consensus is for a weak June personal spending report of +0.1%, matching May’s report of +0.1%. On a year-on-year basis, personal income and spending were both strong in May at +3.5% y/y and +4.2% y/y, respectively.
U.S. ISM manufacturing index expected to remain strong — The market consensus is for today’s ISM manufacturing index to show a -1.3 point decline to 56.5, reversing about half of June’s +2.9 point increase to 57.8. Even if the ISM index today falls by -1.3 points, however, it will still be at the relatively strong level of 56.5, illustrating confidence among U.S. manufacturing executives. Positive factors for the U.S. manufacturing sector include stronger world economic growth and this year’s decline in the dollar that has boosted the competitiveness of U.S. manufacturing exports. Negative factors for the U.S. manufacturing sector include weakness in the U.S. auto sector and dimmer prospects for the U.S. oil drilling industry.
The U.S. manufacturing outlook is particularly favorable given that the ISM new orders sub-index has risen by +6.0 points over the last two months to 63.5, which is just -1.6 points below the 8-year high of 65.1 posted in February. The strength in the new orders sub-index indicates that manufacturing executives are seeing a strong pipeline of orders, which is a positive leading indicator for the manufacturing sector as a whole.
Meanwhile, today’s final-July Markit U.S. manufacturing PMI index is expected to be revised slightly lower by -0.1 point to 53.1, which would still leave the final-July index up by +1.1 points from June.
U.S. vehicle sales expected to show a mild rebound from 2-3/4 year low — The market consensus is for today’s June total vehicle sales report to improve to 16.80 million from June’s 2-3/4 year low of 16.41 million units. Vehicle sales have plunged this year from the 12-year high of 18.29 million units posted in December 2016 to May’s 2-3/4 year low of 16.41 million units.
The bad news is that truck sales have joined auto sales in moving lower. The surge in truck sales in the past several years was the only factor supporting vehicle sales as a whole since auto sales have been falling for the last 1-1/2 years. Auto sales in May in fact fell to a new 6-1/4 year low of 5.68 million units.
Vehicle sales this year have been hurt by (1) cautious consumer spending in general, (2) high ticket prices for new vehicles, and (3) tighter auto credit due to rising bank losses in sub-prime auto loans.