US CPI miss

US CPI miss sees rush to price in 2 rate cuts from the Fed

US price growth eased last month, with headline price flatlining MoM and monthly core prices rising by 0.2%, below the 0.3% expected. The annual rates also declined, falling to 3.3% for headline and 3.4% for core. Headline inflation was driven downwards by the declining oil prices and the sharp decline in gasoline prices in the month. Energy prices rose a mere 0.2%, a touch lower than the rate for food prices. Core service prices continue to drive inflation. They rose by a 3.1% annual rate, the same rate as April.

When economic data cancels each other out

Overall, this confuses the outlook for the US economy: jobs growth is strong, yet inflation is moderating. What should the Fed do in this situation? If the market reaction is anything to go by, then the Fed will be dovish later on this evening when they announce their latest policy report. The 2-year Treasury yield fell 13 basis points, reversing Friday’s gain after the bigger than expected payrolls report. From a market perspective, the payrolls report and the CPI report cancelled each other out.

Will one data point sway the Fed?

Heading into the CPI report it felt like the latest inflation data would determine the outcome of tonight’s Fed meeting. The market has already priced in a dovish Fed: there is now a 65% chance of a September rate cut. We have spoken before about the volatility generated by the Fed’s commitment to data dependency – expectations for interest rate cuts rise when the data is weak or lower than expected and fall when the data comes in stronger than expected. The risk is that the market has got ahead of themselves pricing in a September rate cut. After all, the Fed will need to balance strong payroll growth alongside falling inflation when it makes its policy decision.

September rate cut comes into view

Some have argued that the Fed will also need to take account of the Presidential election in November when they make a decision to cut rates. However, we think that a cut in September is still far enough away from election day to be a feasible option. But, if the Fed signals that it could cut rates in September, then we think they will have to put more faith in the household labour market survey (the unemployment rate) than the establishment survey that calculates the NFP report.

Is the NFP overstating the strength of the US labour market?

The unemployment rate ticked up to 4% in May, the highest level since 2021. Also, the household survey calculates that there are 400,000 fewer employed people compared to a year earlier. Due to this, the NFP data, which is reporting a 232k monthly rate of job growth in the US could be overstating things. If the Fed does put more value on what the uptick in the unemployment rate is telling us about slack in the labour market, then we think a September rate cut could be on the cards.

Are two rate cuts from the Fed realistic?

If the Fed does cut rates in September, what will they do after that? Will they cut again this year? If the Fed believes that inflation will continue to fall, and there are some reasons to believe it will, including oversupply in the oil market keeping a lid on crude and gasoline prices, then they could signal that they will cut rates twice this year. This would be a dovish move from the Fed, and one they may not be willing to make at this meeting. The market thinks that there is a high chance that this will happen. Not only is there a 65% of a September rate cut, but the US interest rate futures market is also pricing in a 75% chance of a second cut in December. As we lead up to tonight’s Fed meeting, the Fed will either be king maker, or the king of disappointment for traders later today.

CPI report drives risk rally

The market is staging a risk rally on the back of the May CPI report. Stocks futures are rising sharply, and the S&P 500 e mini future is pointing to a break above 5,400 for the S&P 500, which would take it to a fresh record high. An extension towards 5,500 would be dependent on a dovish Fed later tonight, especially if they point to two rate cuts this year, anything less than that could see the rally peter out in the short term.

However, we would add that the overall US index may continue to rally even with a less dovish Fed later this evening. US indices managed to reach record highs on the back of stronger than expected data, and weaker than expected data. This is because the rally is being led by big tech, in particular Apple and Nvidia, who are anti-cyclical, and seem to be immune to the Fed’s rate hiking cycle.

European stocks in recovery mode

The US CPI report is also giving European stocks a chance to recover. The Eurostoxx index is up by more than 1%, and French 10-year bond yields are also lower as a mixture of a global bond rally (yields lower) and a commitment from President Macron that he would not resign on the outcome of the Parliamentary elections that will conclude on 7^th July, have calmed markets.