US inflation report - strong market response
A recap of the Wednesday data and its effect on the market
On Wednesday we had a strong risk-on mode after the long awaited US CPI print, that came out softer than expected.
July's US CPI report was a sight for sore eyes, but macro damage is already done. Risk loved it but inflation is still high and Fed is still on course to deliver above neutral tightening in record time.
While the year-over-year reading of CPI inflation declined from 9.1% in June to 8.5% in July, median CPI and trimmed mean CPI came in at 6.3% and 7.0%, respectively, indicating inflationary pressures remain broad-based.
We believe the recent strong market rally, with Nasdaq up more than 20% from June lows, could fade during the next few weeks.
While risky assets cheered the "soft" CPI data, bonds (the smartest assets out there) did not. In fact, the US Treasury 10 year has practically given back the inflation print move... equities not so.
CPI economic data report
CPI was cooler than expected for both the headline (MoM 0% vs 0.2% expected and 1.3% previous; YoY 8.5%, 8.7% and 9.1% respectively) and the core measures (MoM 0.3% vs 0.5% expected and 0.7% previous; YoY 5.9%, 6.1% and 5.9% respectively) primarily led by the 4.6% decline in energy prices, gasoline down 7.7%, Airfares down a similar amount largely due to the gasoline drop and car rentals had a near 10% drop. However, inflation pressures remain strong especially in the core services sector with by still buoyant increases in residential rent prices.
While this may be an indication that inflation has peaked, it is still at considerably high levels compared to inflation targets of circa 2% and the pace of decline from here matters more than the absolute trend.
Even if the Fed will likely be welcomed by this latest report, speakers continued to be hawkish. Fed speaker Evans and Kashkari were both on the hawkish side despite being some of the most dovish members on the Fed panel. Evans again hinted that tightening will continue into 2023 as inflation remains unacceptably high despite a first sign of cooling prices. The strength of the labor market continued to support the case of a soft landing. Kashkari reaffirmed the view on inflation saying that he is happy to see a downside surprise in inflation, but it remains far from declaring victory. He suggested Fed funds rate will reach 3.9% in 2022 (vs. market pricing of 3.5%) and topping 4.4% at the end of 2023 (vs. market pricing of 3.1%).
The markets played out as expected for a downside miss: stocks rallied, US Treasury 2y/10y inverted further (now at -50bps) and rates dipped in the front end by more than 20bps.
Fed talk
Evans stated that he does “not expect that we’re finished with rate hikes”.
Kashkari stressed again that he felt it was “unrealistic” to expect rate cuts early next year. He also felt that rates could be around 3.9% by year end and that we are “far from declaring victory on inflation”. His favoured path would be a series of more hikes before pausing to see a clear trajectory for inflation back to 2% target before easing.
Daly was a little less hawkish with her estimate of 3.5% for year end rates and felt that 50bps hike for September was her “baseline”. Whilst agreeing that prices remained “far too high” she felt there were signals to support smaller rate increases.
Fed whisperer Timiraos said in his column that with the hot labour market 75bps was still an option for September and they would want to see further evidence of a slowing in inflation.
Analysts’ opinions:
Derek Holt, an economist at Scotiabank: whether it’s 50 or 75 in September is probably going to go down to the wire, but it’s premature to judge the September move.
Michael Pond, the head of inflation strategy at Barclays: the July CPI prints makes it more likely that our call will be right for the September FOMC – a hike of 50 basis points […] It’s in the right direction, but we’re certainly not there yet.
BNP Paribas: while much of the recent data (NFP, ECI, AHE) will keep a 75bp move in September on the table, the cooler-than-expected July CPI should keep the Fed on track for to hike by 50bp, in our view. A 75bp hike remains a plausible risk scenario, and the September decision will remain contingent on the next round of CPI and payroll data, both of which will be in hand before the 21 September FOMC.
Diane Swonk, the chief economist at KPMG: the greater risk for the Fed is to stop too soon than stop too late. It will take a lot more cooling than this for the Fed to shift its decision rule.
James Knightley, chief international economist at ING: Core inflation remains on an upward trajectory due to rising housing rental costs and service-sector inflation pressures.
Citigroup: we would caution that details of the report still point to very strong underlying inflation. Weakness was largely concentrated in components like used cars, hotel prices, and airfares, while shelter prices and general services remain very strong.