With inflation pressures building in some key places stated here many times, such as in commodities and trucking, the question is how companies will deal with it in terms of absorbing it via a cut in profit margins, cutting costs or will they try to pass it on. This is what Deere said today in their earnings press release: “we are experiencing higher raw material and freight costs, which are being addressed through a continued focus on structural cost reduction and future pricing actions.” That latter of course is code for higher prices.

Another month and another wide separation between the inflation the Bank of Japan wants and what is being delivered in their monthly stats. April CPI ex food (their version of core) was up .7% y/o/y, one tenth less than expected and down from .9% in March. The core/core rate which also takes out energy saw CPI up by .4% y/o/y as expected vs up .5% in March. Quite the distance from the arbitrary desire for 2%.

I’m at a rare loss of words but I’ll give some anyway. Did Kuroda see this data overnight and say I need to print even more money or is there any light bulb there that flashes a sign and says, ‘maybe this plan is not working and I should give up’? Their balance sheet as a percent of GDP is at 96% vs about 30% when Abenomics became a household word in Japan. JGB yields were little changed overnight but the yen is weaker which in turn helped to rally Japanese stocks. The yen selloff from 78 to where it is today over the last 5 1/2 years also of course didn’t help much in getting to 2% inflation. The only thing that did was the VAT increase a few years ago. The next VAT hike might come next year.

BoJ BALANCE SHEET AS % of GDP

Thanks to a lift in energy prices, German PPI in April was up by 2% y/o/y, two tenths more than expected and up one tenth from the pace seen in March. Inflation expectations as measured by the 10 yr breakeven is unchanged at 1.41% but that is holding at the highest level in 4 years.

GERMAN 10 YR BREAKEVEN

The mess in Italian bonds continues as the 2 yr yield is up 7 bps to +.09%, now up almost 40 bps this week. The 10 yr yield is up by 8 bps and higher by 33 bps this week. Italy certainly has its own political issues along with a massive debt level but they always seem to. What happens come October 1st when QE is most likely cut again? We’ll see but I’m sure there will be much more of a focus on those countries that don’t have their s**t together in terms of debts, deficits, policies, etc…

The Italian stock market is still the best performing in Europe but is down 3% over the past 3 days led by the banks. In fact, the Italian banks are the worst performers today in the Euro STOXX bank index. This is a good time to include a chart on this index. Note that NIRP started in June 2014.

Euro STOXX Bank Index

Industrial production in April was a bit better than expected with its .7% m/o/m gain vs the estimate of up .6%. Also, March was revised up two tenths. The manufacturing component though was as forecasted so the upside gain came from higher utility output and mining (oil and gas helped). Auto production fell after the sharp rise in the two prior months.

Bottom line, the recovery in commodities and the best level in manufacturing production in this recovery helped to lift IP. Manufacturing production though still remains below the 2007 peak. Capacity utilization moved up to 78% from 77.6% but that still remains below the long term average of 80% and helps to explain why capital spending hasn’t accelerated. This number is never market moving but we might see a modest upside tweak to Q1 and Q2 GDP estimates.

MANUFACTURING PRODUCTION

Housing starts in April totaled 1.287mm, 23k less than expected but that was mostly offset by an upward revision of 17k to the March figure to 1.336mm. Single family starts were little changed in April and really have been pretty flat over the past 4 months at around 890-900k. Thus, multi family has been the main driver of the month to month volatility and they’ve certainly been volatile. In December multi family starts totaled 363k then went to 448k in January, back down to 390k in February, up to 443k in March and down to 393k in April. Overall permits were about in line with expectations, rising slightly for single family and multi family giving back some of the March spike.

Bottom line, housing remains in this back and forth benefiting from a strong labor market and what looks like finally rising wages on one hand and higher interest rates, 5-6% house price inflation and a dearth of home inventory on the other. For single family the end result is a stall in starts as the peak this cycle was seen in November while multi family building remains robust due to low vacancy rates, persistent rent increase and a secular move to renting. Specifically with the increase in mortgage rates, typically the initial reaction is to rush to lock in and make your transaction, the so called fence sitter effect. We then see what the fall off will be as people then take stock of their new potential higher monthly bills. As stated this morning, it was 5 weeks ago the last time there was an increase in home purchase mortgage applications. In last Friday’s UoM consumer confidence index, those that said it’s a Bad Time to Buy a Home rose to match the most since August 2011. That was the month when S&P downgraded the US credit rating. Not including that month, go back to 2009. People make spending decisions on their monthly payment but hopefully wage growth and maybe some moderation in home price increases will offset the rise in rates.

SINGLE FAMILY HOUSING STARTS

I’ve spoken for a while about rising trucking costs and what that will eventually mean for consumer prices on every single item that gets trucked. At least on the former it is becoming obvious everywhere and many companies talked about it on their recent earnings conference calls. In yesterday’s Case Freight Index report it was titled “Volume Strong, Pricing Even Stronger – Capacity Still Tight but Less Tight.” On the latter though, “That said, demand is still exceeding capacity in most modes by a significant amount. In turn, pricing power has erupted in those modes to levels that spark overall inflationary concerns in the broader economy.”

In yesterday’s Almost Daily Grant’s, Jim Grant talked about rising trucking costs and took some quotes from the biweekly Morgan Stanley Truckload Index: “Flatbed capacity is exceedingly tight and will likely tighten further as milder weather finally arrives in northern regions. There seems to be very large imbalances regionally; creating ‘panic’ freight buying” according to one anonymous shipper. The CFO with Melton Truck Lines said “We have not seen a rate environment like this for a long, long time, if ever.” The CEO of Brenny Transportation said “I’ve never seen anything like this in more than 30 years in business. Volume was at least manageable a year ago. We were doing well and rates were good. But now it’s out of control and we can’t keep up.” She went on to say that last year shippers waited 3 days to get a truck and now are waiting 10-14 days.

As a result of this and other factors (oil, etc…), the 10 yr inflation breakeven yesterday closed at 2.19%, the most since August 2014 and certainly helps to explain rising interest rates. On the inflation equation, we’ve had 2.5-3% services inflation ex energy for years. What has been the offset was a decline in goods prices. Now we will see a rise in goods prices at the same time service inflation remains at the same level.

We’re hearing from some about ‘peak earnings’ but that question needs to be refined to have we reached ‘peak margins’ due to this rise in costs, interest rates, commodity prices and wages. I believe we have but hopefully it can be offset or at least cushioned by revenue growth.

Adding more drama to global bond markets, in the talks between The League and The Five Star Movement in Italy, they discussed writing off 250b euros of Italian debt that the ECB owns. What a way to freak out bond holders in the 3rd largest sovereign bond market in the world. This follows the budget busting proposals out a few days ago and what you have is a continued spike in interest rates. The 2 yr yield which closed at -.28% on Friday is now at +.01%, up 8 bps on the day and is positive for the first time since last April. The 10 yr yield is up by 9 bps and back above 2%. With negative interest rates most likely ending next year, that buyer of Italian 2 yr BTP’s on Friday might never be made whole.

ITALIAN 2 yr yield

In March, foreigners were net sellers of US notes and bonds totaling $4.9b but are still buyers year to date of $46.7b after a lean 3 years where they were net sellers of more than $330b. China, the largest holder, did add to their Treasury holdings but it was all due to an increase in bills as they were sellers of notes and bonds. Japan’s holdings, the 2nd largest, fell for the 7th month in the past 8. We can add the Fed’s QT, its increase in the fed funds rate and a reduced pace of foreign buying of Treasuries to the other factors mentioned to explain the rise in US interest rates.

The rise in interest rates is now filtering into the US housing market. The MBA said mortgage applications to buy a home fell for the 3rd straight week and was flat in the week before that. Thus, it was April 13th the last time we saw an increase. It fell 2.1% w/o/w to a 5 week low but is still up about 4% y/o/y. Refi’s fell for a 4th week by 3.8% and are down by 17%. The refi index is at the lowest level in 10 years.

Bullish sentiment rose on the week according to II. Bulls were up to 46.6 from last week’s 4 week low of 43.1 and the Bears fell by 1.2 pts to 19.4. While the spread of 27.2 is still well off its January peak of about 50, it remains wide. Again, sentiment follows price. We see housing starts at 8:30am.

The Japanese economy contracted in Q1 by .6% q/o/q annualized. That was worse than the estimate of down .1% and Q4 was revised downwards. Business spending went negative and personal spending did not grow. The uneven nature of Japan’s recovery continues while the BoJ owns 40% of the JGB market. If only they buy a little bit more, everything will be fine.

Lastly, in case you missed the testimony yesterday, our new Fed Vice Chair Rich Clarida is no dove. He agreed with QE1 but after that “the benefits of QE diminished as more and more rounds were added.” Jay Powell wasn’t a fan either based on transcripts. Clarida also believes their balance sheet should only hold US Treasuries. The Fed still owns $1.7 Trillion of MBS securities. This is no longer the Bernanke/Yellen Fed. That put is way out of the money.