On the surface, the big data out of the US on Wednesday confirmed US CPI expectations for easing. Inflation was lower, as expected. Yet the market reacted by going in the opposite direction, pricing less easing by the Fed and yields higher. Typically, that means the dollar should have gotten stronger. But it was largely unchanged. The main dollar pairs moved more on Tuesday than on Wednesday. Why did that happen?
The thing is, markets are resoundingly convinced that the Fed will cut rates in September. despite concerns about services inflation, There might be some quibbles about how much between the September and October meetings, but substantial easing is expected shortly based on US CPI expectations. That means the market is likely reacting more to the longer-term outlook (as in, to the end of the year) and whether or not the US is likely to slip into a recession. That can cause the market to focus more on certain components of the data instead of the headline-catching numbers.
What Was the Big News?
The bit of the data that captured most of the headlines was that the inflation rate dropped to 2.9% from the 3.0% that was expected to be repeated in July. That was the lowest it has been since March of 2021, back when the Fed was talking about being tolerant of inflation going above target ‘temporarily’. The core rate, which is more closely followed by the Fed, also was lower than the prior month, when economists had expected it to be essentially unchanged. Both of those indicated that inflation was going in the right direction for a cut. So, cut for September remained priced in.
What shocked the market was the so-called “supercore” interest rate, which strips away food, energy and housing. Housing has been driving a lot of the inflation lately, with US home supply being restricted due to the high interest rates. Many analysts are therefore discounting it as a “true” measure of the price pressure. But also, Fed officials have said several times that they are worried about services inflation. And the ‘supercore’ largely measures that
The Bounce Back Up
This measure of services inflation rose 0.2% in July, compared to -0.1% in June. And it was the first time that it was inflationary in the last three months. In other words, since Q1. That services costs were rising while jobs growth and consumer sentiment are seen as weak spooked the markets a little bit. That’s what pushed the yields higher initially, before they settled back down, leaving the dollar generally unchanged when compared to other currencies like the pound and Euro.
But over the last couple of days, the EURUSD has been higher. That’s because producer prices were reported on Tuesday, and they also showed a faster deceleration than expected. This is important for forward looking inflation, as producer prices typically filter through the economy over a couple of months. In other words, inflation is expected to keep going down through the rest of the year.
The market was pricing in more than 50% chance that the Fed would cut by 50bps in September, and keep cutting through every meeting for the rest of the year. Following the data, that has been adjusted to the market now expecting that “double” rate cut to be in October. But the market is still expecting to end with a total of 100bps of cuts, so the overall trajectory remains unchanged.
