The carnage after the CPI storm

The most hotly awaited economic data release of the week, the US CPI, was hotter than expected. Both the headline and core rate of CPI were stronger than expected, and rose by 0.4% on the month. The annual rate of headline CPI rose to 3.5%, the highest level since September. The core rate held steady at 3.5%. So, is the disinflation trend over? Can the stock market rally continue?

US rate cut now expected in November!

The immediate aftermath of the CPI report has been a bloodbath. The Dow is down by 440 points and the S&P 500 is lower by more than 1%. The 10-year Treasury yield, which had fallen by 10 basis points this week, reversed course and is higher by 12 basis points on the day. The market has once again recalibrated US rate cut expectations, and the verdict is that that first rate cut may not come until November. The market is now pricing in less than 2 rate cuts from the Fed for this year. What a turn around, only a few months ago the market was expecting 6 cuts.

Why US inflation is a problem of affluence and economic strength

Has the market gone too far? Possibly, however, inflation is sticking around longer than anyone would like and is set to be the key economic theme of 2024. The key component of CPI in March was surging core service prices. This moved higher by 3.17% YoY. In contrast, food price inflation remain low, and core goods prices actually fell in March compared with a year earlier.

The US’s inflation problem is not because of a bad economic dynamic or poor supply chains, it is a problem of affluence. The US’s economy is strong, the consumer feels strong and they are eating out at restaurants and buying clothes, which is why the prices of these things are rising.

Why the US has a tricky inflation puzzle to solve

Digging into the key drivers of March’s spike in inflation, and you see that shelter costs are still a major contributor to core inflation in the US. The shelter index is up 5.7% over the last year and contributed more than 60% of the total 12-month increase in core inflation.  Analysts are pointing to immigration and a strong labour market putting upward pressure on shelter costs. Considering these two things are vital for US economic growth, high shelter costs could be here to stay. Gasoline prices are also rising as

we lead up to the summer driving season. Up until January, energy commoditities were net negative for CPI, since February the energy component of inflation has started to turn posoitive, and this is also why CPI has reaccelerated. The dual factors of sticky shelter costs weighing on core inflation and higher energy costs caused by international factors outside of the Fed’s control, show how hard it will be for the US central bank to 1, cut rates and 2, bring down inflation to the 2% target rate.

The Super core rate of inflation is also on the move higher

The super core rate, which strips out shelter costs, also suggests that the disinflation trend has stalled and will not be easy to reinstate. The Bloomberg super core inflation index for March rose to its highest level since May 2023 in March, and at 4.8%, it remains well above the Fed’s 2% target rate.

When inflation misses are no longer a blip

The Fed chair Jerome Powell called the recent higher than expected inflation rates ‘bumps along the road’. After March’s higher than expected inflation reading, this looks less like a bump in the road, and more of a pathway towards higher for longer inflation, and higher for longer interest rates. Will Powell row back on these words? This is the last CPI report before the next FOMC meeting at the end of April. This will be critical for the direction of markets. Tonight’s FOMC minites are fairly out of date by this stage, although it will be interesting to see what the hawks like Raphael Bostic think about the path for interest rates, even before the mega payrolls report and the strong March CPI reading. There are a plethora of Fed speakers in the coming weeks, and they will be worth watching closely. Will the rest of the Fed members move towards Bostic, who said that he expects only one rate cut from the Fed this year? After today’s CPI report, that does not seem too outlandish.

Too far, too fast?

The markets are likely to remain volatile. After a particularly vicious reaction, stocks might settle down later this afternoon. However, the strong CPI report is likely to interrupt stock market momentum. However, the strong CPI report, as we mention, is also a problem of affluence, and a sign of a strong economy. The US can handle rates at this level, the risk now is if the Fed needs to hike rates further towards 6%. We think that is a low risk probability, but then at this stage so are three rate cuts from the Fed this year.

The market gets less dovish on BOE and ECB rate cuts

In the FX space, the dollar index is strong, and is higher by 0.8% vs, the euro and USD/JPY is back above 152.00 so far on Wednesday. There is now a real risk of more intervention from the BOJ to stem the yen’s decline. However, the downside in euro and GBP could be protected, as German and UK 10-year sovereign bond yields have also risen on the back of the US CPI report. The German 10-year yield is up by 5 basis points, the 10-year Gilt yield is up by 9 basis points. The market is also pricing out the potential for the ECB and the BOE to cut rates before the Fed. The market now expects the first rate cut from the BOE in August. Next week’s UK CPI report will be crucial in determining if the BOE does cut rates in the first half of this year. If UK CPI follows the same trend as the US, then the chances of that happening are slim.