Tariff inflation arrives | USAEMALL.com

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Good morning. Donald Trump announced a trade deal with Indonesia yesterday. Indonesia will be hit with a 19 per cent tariff on exports to the US — the initial threat was 32 per cent — and in return it will buy American oil, aeroplanes and farm goods. This is the closest thing to a real agreement since the deal with Vietnam. But neither Vietnam nor Indonesia have confirmed Trump’s claims. Should we buy them? Email us: unhedged@ft.com. 

Inflation

Both headline and core inflation picked up in June. The core figure, the one we care about, rose from 2.8 per cent to 2.9 per cent. But the modest increase was about as expected.

Looking closely, though, the report provided solid evidence that tariffs are pushing prices up. Core goods prices rose 0.2 per cent, driven by household appliances, clothing and furnishings — the very categories that analysts have long predicted would show tariff inflation first. “Prices rose especially sharply for goods which are primarily imported, and less quickly for those that are mainly made in the US,” said Samuel Tombs at Pantheon Macroeconomics. This chart from Tombs shows price changes relative to import intensity, a measure of how much each class of good is imported from abroad:

Unhedged’s preferred metric, annualised month-over-month change in core CPI, continues to show the disinflationary trend weakening:

The market moved on the news — gently. Both 10-year Treasury yields and 2-year Treasury yields rose 5 basis points. That seems to mostly reflect inflation expectations. One-year inflation swaps started rising last week, after Trump started ratcheting up his tariff threats, and rose again yesterday:

Futures-implied Federal Reserve rates did move down yesterday, but only a touch. Investors are still expecting between one and two cuts by the end of this year.

There was good news in the inflation report, too. Shelter prices, a long-standing problem for the Fed, have fallen sharply over the past two months. And vehicle prices fell in June, despite the 25 per cent tariff on cars. According to Tombs, had it not been for auto prices, core goods prices would have risen 0.5 per cent between May and June, the highest monthly change since June 2022, in the throes of post-pandemic inflation.

Most analysts argue this is just the beginning of tariff-induced inflation. Companies have been running down existing inventory and absorbing tariff costs as they wait for clarity on Trump’s “deals”; that can’t go on forever. Timely data shows that some car manufacturers, for example, are starting to raise prices, said Bradley Saunders at Capital Economics. Tom Porcelli of PGIM estimates that headline inflation could get as high as 3 per cent to 3.5 per cent in the next year as tariffs solidify.

Porcelli and many others argue that tariff inflation will be largely transitory. But until the Fed knows the level at which the president’s tariffs will settle, it won’t be able to shrug them off. If the labour market sours before we get that clarity, the Fed will have tough choices to make. 

(Reiter)

Treasury investors’ blues

We are living in one of the worst periods in history for Treasury investors. Nominal returns on the benchmark 10-year Treasury are at an all-time low on a trailing 10-year basis. In real terms, things aren’t quite as bad as they were in the 1970s or after the world wars, but they sure ain’t pretty. Charts from Deutsche Bank:

There are various ways to measure Treasury returns, but similar trends show up regardless of method. Aswath Damodaran at NYU Stern calculates the return on the 10-year bond over 1-year holding periods by taking the coupon rate at the end of the previous year and subtracting the price change of a bond with that coupon rate. Returns vary a lot by year, but the same lousy trend is visible.

The reasons are well understood. Post-Covid inflation led to Fed rate increases that crushed bond prices even as inflation reduced real returns, culminating in the nightmarish year 2022, when bonds were crushed alongside equities. But what matters is what investors should expect in the next 10 years. Here’s Scott DiMaggio of AllianceBernstein: 

If you look at the next 10 years — and 10 years is really hard to gauge — we think the neutral rate for the Fed is around 3 per cent. So the 10-year is probably somewhere in the 3.75 per cent range. So if you think of that as a pretty good predictor of where returns will be, you’re probably looking somewhere in the area of a 4 per cent, 4.25 per cent [nominal] return. 

Accounting for inflation expectations, DiMaggio estimates returns in the 2 per cent range. That’s not nothing, but it is a huge shift from what investors have come to expect during the long bond bull market that ended in 2022. Between 1980 and 2010, according to the Credit Suisse Investment Returns Yearbook (RIP!), annual real returns on Treasuries bonds were 6 per cent a year annualised.  

Whether returns will be much better or worse than DiMaggio’s 2 per cent central forecast depends mainly on inflation, of course. That uncertainty is built into yields in the form of a risk premium, as Christopher Brigati of SWBC explains

We’ve had a remarkable amount of uncertainty as of late — we don’t know what the next move is going to be, when the next tariff is going to drop. That adds a layer of uncertainty and unease to the market. As a result, we’re seeing a little bit more of a term premium coming into the market. People require, and expect, better performance and better returns.

Here, in light blue, are KPMG’s estimates of the inflation risk premium:

If the inflation picture becomes clearer, and tariff inflation doesn’t materialise, Treasury investors will harvest that premium. For the longer term, however, it would be dangerous to plan on real returns of more than a per cent or two from your portfolio’s Treasury allocation. The golden age is over.

(Kim)

One good read

EV wars.