What Is Inflation? High Yield: We told you so!

• PPI was higher than expected on price increases for drugs, tobacco and vehicles. • Lower fuel prices are beginning to lift consumer spending. Are lower fuel prices inflationary? • JPM prices a new five-year note at +135 to the five-year Treasury. Spread tightening is in full swing. • Bloomberg reports that high yield investors and fund managers move up the quality and liquidity scale. Bond Squad suggested such a strategy many months ago. • Is Bond Squad really on vacation? Which data set tells the real inflation story, the headline data or the core data? Headline PPI indicates that inflation is a non-event. However, the core data indicate that inflation is beginning to heat up. The answer to the question of why there is a big discrepancy between the headline and core PPI readings lies in gasoline prices. On a year-over-year basis, gasoline prices are down 7.9%! The price decline in a good (commodity) which has a very inelastic demand curve has resulted in more free cash for with consumers can use to spend. We have argued that higher fuel prices can have a deflationary and sales-sapping effect on the overall economy. Other than the Fed and supply-side economists, we have had few advocates in our corner. For the past decade, the trend has been one of higher fuel prices. In spite of the fact that the higher headline inflation data clearly constrained consumers (requiring extraordinary Fed accommodation in 2003 to spark consumer spending, helping to inflate the housing bubble), many pundits held the belief that inflation is inflation and that the Fed should tighten regardless of from whence it comes. Simple theories for simple minds we guess. The evidence points to the fact that lower fuel prices (and lower prices of necessities with inelastic demand curves) can spark inflation in the broader economy as consumers begin to spend their newly-found surplus income in sectors of the economy which are far more influential on economic growth. However, for our theory to be proved correct, lower prices for goods with inelastic demand curve would need to translate into better retail sales data. Voila, retail sales increased last month as fuel prices fell. To be fair, fuel prices fell in May (-8.9% MoM) April (-1.7%) and March (-2.0%) while Retail Sales (ex-autos and gasoline) increase only in March, but consumers are cautious. During those months, the savings rate increased. Consumers finally began spending their surplus cash in July. The high yield bond game may be entering the fourth quarter. Bloomberg News is reporting that high yield fund managers are moving into more liquid high yield bonds. The article states: “High-yield fund managers investing a record $44.9 billion of deposits this year are selecting bonds they can sell more easily if investors start withdrawing the money. Even as the Standard & Poor’s 500 index returned 3.4 percent since the end of June, typically a benefit to the riskiest debt, the highest- rated junk bonds have outperformed the lowest-ranked by 0.4 percentage point, Bank of America Merrill Lynch index data show.” Barclays credit strategist, Michael Kessler, stated: “Investors are right to be nervous about holding less- liquid paper. What’s different now is that it’s happening during a pretty significant rally.” What today’s article states, Bond Squad has been saying for many months. This is yet another instance where Bond Squad subscribers have been ahead of the curve. If anyone would like a copy of the article, drop us a line. For complete reports and much more, subscribe to Bond Squad. The following packages are available: Subscribe for 1-year and receive "Making Sense" Full Access (daily e-newsletter and phone access to Tom directly during business hours of 8am EST- 4pm EST) at the discounted price of $250. If you prefer to receive the Reports Only (with no access to Tom directly), the rate is just $150 per year. www.bond-squad.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.