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How will consumption shape investments after the payrolls report?

Part 11
How will consumption shape investments after the payrolls report? (Part 11 of 12)

Will producer prices this week calm the Fed’s inflation concerns?

What is the Producer Price Index (or PPI)?

The Producer Price Index (or PPI) is a headline inflation number issued by the Bureau of Labor Statistics (or BLS). The PPI for March will be released on Friday, April 11. The headline PPI measures price change in finished goods, termed “for final demand.” Price changes for goods, services, and construction sold to final demand are captured by the headline number.

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Highlights from February’s report

The PPI for final demand (or FD) decreased 0.1% in February on a seasonally adjusted basis.

On an unadjusted basis, prices for finished goods increased 0.9% for the 12 months ended February 2014 compared to a 1.2% advance in January 2014.

While the PPI for final demand (or FD) goods increased 0.4%, decreases in final demand services (which were down 0.3%) accounted for the decline in the PPI for FD prices. A large part of the decrease in the final demand services index was the decrease in prices for trade services, which were down 1%. Trade indexes measure changes in margins received by wholesalers and retailers. Over 80% of the February decrease in the index for final demand services can be attributed to margins for apparel, footwear, and accessories retailing, which fell 9.3%.

This further underlines the challenging environment most retailers face. Some home improvement retailers, though, like S&P 100 Index (OEF) components Home Depot (HD) and Lowe’s (LOW), are experiencing stellar sales due to the boom in residential construction and housing. The iShares U.S. Home Construction ETF (ITB), which tracks the performance of the Dow Jones U.S. Select Home Construction Index, includes positions in both Home Depot (HD) and Lowe’s (LOW).

Implications for fixed income investors

A decrease in the PPI will imply that inflation is falling—which, other things remaining constant, would mean lower nominal yields for bonds (AGG) and higher prices, and vice versa. The Fed has indicated that price stability in the form of long-term inflation at the 2% level is one of its primary mandates. Should indicators like the PPI show that this level is unlikely to be reached in the near future, the Fed would delay raising the Fed funds rate, keeping yields low for fixed income securities at the short end of the yield curve.

However, with economic expansion underway, the yield curve has steepened—yields for long-term debt securities have risen faster than yields for short-term securities, which has put pressure on the prices of long-term fixed income securities like the Core Total U.S. Bond Market ETF (AGG) and the Vanguard Total Bond Market ETF (BND).

To read about the lone housing market indicator due to release this week, continue to Part 12 of this series.

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