The PCE Reading and Why It Was No Surprise
The most recent Personal Consumption Expenditures (PCE) inflation report came in elevated, exactly meeting expectations. While the headline figure confirmed inflation remains elevated, the lack of surprise is itself instructive. Because the Producer Price Index (PPI) and Consumer Price Index (CPI) are released before the PCE figure, economists are able to map the underlying components of those earlier reports onto the PCE. As a result, by the time the PCE number arrives, much of its content has already been anticipated and priced in. The report meeting expectations, therefore, was not a meaningful shock to the market.
Inflation, Not Oil, Is Driving Long-Term Yields
The more important story lies in what is driving the longer-term portion of the yield curve, which right now is the inflation narrative. A useful illustration of this is the relationship between the price of oil and the 10-year Treasury yield. Following the onset of the Iranian crisis, oil and the 10-year yield moved closely in tandem with one another. More recently, however, there has been a significant pullback in the price of oil, and the two have diverged.
That divergence carries a clear signal: the market is now more concerned about the broader inflationary outlook — and the possibility that inflation is becoming embedded in underlying economic conditions — than it is about where oil prices go from here. The practical implication is that even a solid, concrete resolution to the Iran situation would not necessarily bring yields down, because the market is trading off the persistent inflation outlook rather than the energy supply story alone.
Is the bond market signaling an inflation problem that goes beyond the energy supply constraints caused by the Iran war? Yes. The bond market is effectively communicating that there is an inflation problem extending past the energy-supply disruptions. Contributing pressures include investment flowing into artificial intelligence and concerns surrounding the federal budget, both of which feed into the inflationary picture independent of oil.
What the Fed Is Likely to Do Next
Fed communication has been notably light this week. The few officials who did speak — including Goolsbee and Williams — were watched closely, with some anticipating they might need to perform a "clean up on aisle three" to clarify the message coming out of the FOMC meeting. In the end, they did not appear to do so, though their remarks still offered a sense of how that meeting unfolded.
Looking ahead, light Fed speak may become the defining theme. Under a Federal Reserve led by Kevin Warsh, the expectation is for considerably less communication regarding the central bank's intentions. This could mean no press conference after every meeting, and potentially the disappearance of the dot plot and the Summary of Economic Projections (SEP) altogether. This more tight-lipped approach to forward guidance is likely to make the upcoming Sintra conference in Portugal especially interesting to watch.
Where is the Fed headed for the rest of the year? The base case is that the Fed is likely to remain on hold for the time being. The market is currently pricing in a rate hike before year-end, but that appears to be too aggressive at this point. That said, it is acknowledged that the next move could plausibly be a hike, because inflation concerns are bubbling up beneath the surface and sticky inflation is a recognized problem. Warsh himself stated during his press conference that sticky inflation is one of the main issues the Fed wants to tackle.
A notable detail from the policy statement: the Fed referenced price stability without mentioning the other half of its dual mandate — stable employment. The omission is worth watching closely, as it may indicate where the central bank's priorities now lie. On balance, however, a Fed that stays on hold for now would not be a surprise.
Positioning: Duration and the Yield Curve
For client positioning, the current recommendation is a below-benchmark duration. As a starting-point proxy, the average investor can look at the average duration of the Bloomberg US Aggregate Bond Index, which is roughly 6 years. Against that benchmark, a duration of 4 to 5 years — depending on individual circumstances — can make sense.
This stance rests on two ideas. First, because the Fed is likely to be on hold for the time being, the penalty for positioning too short on the curve is not especially great. Second, there is genuine potential for upside in longer-term yields from current levels. The working view for the rest of the year is that the 10-year Treasury will trade in a range between 4% and 4.5%. However, a case can be made for higher long-term yields driven by three forces: higher inflation expectations, an elevated term premium, and a Fed on hold. Given that combination of risks, it does not make sense to take on large duration bets in the current environment.
Positioning: Credit Opportunities
On the credit side, opportunities can be organized into a core sleeve and a more aggressive income sleeve.
Within the core sector, the investment-grade space is attractive. While it is true that spreads are relatively tight, the absolute yield that investment-grade corporate bonds offer helps offset that tightness, making them compelling on an all-in yield basis.
Within the more aggressive income sleeve, the more favorable instruments are preferred securities and high-yield corporate bonds. The logic is similar: although spreads are tight, the absolute yields remain relatively attractive. With the economy continuing to chug along, credit concerns for this part of the market are not a significant worry at present.
What to Watch Next
The week ahead is expected to be quiet, coinciding with the holidays, the onset of summer, and correspondingly light, thin trading volume. What is the next catalyst on the radar? There are no major or notable data releases scheduled for next week, so economic data is unlikely to move the needle in either direction.
Instead, the key variable to watch is the geopolitical situation — specifically, whether a very concrete resolution emerges in Iran. If that happens, inflation expectations could ease somewhat; indeed, TIPS break-even rates have already moved lower, a sign that some inflation premium is already coming out of the market. Barring a fresh flare-up of geopolitical issues, next week should be a light, low-volatility stretch.
