US PCE: Defining the Fed’s Rate Cut Path
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The market is universally agreed that there will be a rate cut when the Fed meets next September 17-18th. The debate is centered around how much the Fed will cut, either at this meeting or the next. But that could get shaken up considerably with Friday’s release of the Fed’s preferred metric for inflation: US PCE Price Index.
So far, inflation has been coming down as expected, leaving the Fed open to cutting rates. Some investors fret that the Fed has waited too long, and this will lead to a hard landing. So, a continuation of that trend will largely reassure markets, and be greeted as generally good news. A sudden bump up in inflation in this indicator – judged as highly unlikely – could give the market some pause in its assessment. While that would likely give the dollar a boost, the stock market and risk appetite as a whole might suffer substantially. Emerging markets might be the most affected as the emerging potential carry trade could be postponed.
What to Look Out For
US July PCE price index on a monthly basis is actually expected to increase to 0.2% from 0.1% from the month before. But this isn’t likely to concern the markets as it fits within a difference of rounding, and still fits within the target rate for the Fed. Besides, the central bank is more focused on the core rate, excluding the recent variations in gasoline prices. This is where things can be a little more complicated.
The Core PCE Annual Price Index changes is expected to be 2.6%, the same as in June. Which means a beat by just the bare minimum would imply that inflation broke the downward trend and that could spook the markets a bit. A beat by more than one decimal could lead traders to reassess just how much rate cuts the Fed will actually get around to doing.
Potential Reaction and the Dollar
It would likely take a substantial beat for the market to swing all the way back to not expecting a rate cut in September. And that could end up causing a much wider issue for markets and risk appetite as a whole. A more likely scenario is that markets would still price in the September cut, but adjust the rate of fall after that.
For now, the market is pricing in a “double” or 50 bps cut for the October meeting, influenced by the latest US PCE data. Any unexpected sign of persistent inflation would likely either push that forward to the December meeting or off into next year. This would provide a relatively minor steepening of the curve, and boost the dollar comparatively. This trajectory would be closer in line to what is expected from the BOE and the ECB, so it could put an end to the rise in cable and fiber. The yen could be the most affected by a potential beat, as it could cause a pause in the unwinding of the carry trade.
Going Beyond the Immediate Reaction
There are potential consequences of the US PCE number being “too good”; that is, a substantial miss. Preliminary PMI data for August showed the lowest price pressure in seven months, so there is a possibility of a miss. The culprit of the miss could be pivotal for the market reaction.
If inflation is ebbing because of lack of demand and oversupply, it could signify that the economy is heading for a harder landing. While this would boost safe havens, the dollar could end up being the worst off as investors move to price in a potential emergency cut by the Fed sometime this year. That could lead to a repeat of the correction seen in markets in early August.