A modestly softer-than-expected inflation reading in the U.S. Wednesday morning had stock markets climbing and bond yields and the U.S. dollar falling as traders price in stronger odds that the Federal Reserve is done with its interest-rate hike campaign.
The Labor Department’s Consumer Price Index rose 4.9% year-over-year in April, against expectations of a 5% increase. It was the first time in two years that headline inflation was below 5%.
On a monthly basis, consumer prices rose 0.4% - which was in line with forecasts. Core prices, which exclude food and energy, increased by 5.5% as anticipated.
S&P 500 futures, which were close to unchanged prior to the data, immediately spiked as much as 1% on the news. The U.S. two-year bond yield fell about 5 basis points to 3.97% after initially being higher. But the Canadian two-year bond yield - which typically tracks its U.S. counterpart - was finding its own direction, up by about 5 basis points.
Bond market futures tied to the Federal Reserve’s policy rate rose after the Labor Department report, and now reflect a nearly 90% chance of the leaving rates at their current 5%-5.25% in June. Traders had priced in about an 80% chance of a June pause just before the report.
Credit markets believe it won’t be long until the Fed will cut its policy rate to combat a downturn in economic growth. Trading in swaps markets suggest an initial 25 basis point cut in September, and traders are pricing in a full 75 basis points of easing by year-end.
For the Bank of Canada, swaps markets are less confident about interest rate cuts this year. They are currently pricing in pretty much equal odds of a 25 basis point cut by December and no move in the bank’s overnight rate at all - a market positioning that was largely unchanged by the 830 am ET U.S. inflation report.
Here’s how money markets are pricing in further moves in the Bank of Canada overnight rate for this year as of 1010 am ET Wednesday, according to Refinitiv Eikon data. The current Bank of Canada overnight rate is 4.5%. While the bank moves in quarter point increments, credit market implied rates fluctuate more fluidly and are constantly changing. The columns to the right represent implied odds of rate moves on a percentage basis.
Not all economists agree with the bond market’s assessment that the Fed will be cutting rates before the year is out, especially as aggressively as 75 basis points. Here’s how they are reacting:
Royce Mendes, managing director & head of macro strategy, Desjardins Securities
Despite traditional measures still showing sticky inflationary pressures, there does seem to have been more progress on taming consumer prices than initially meets the eye. ...
Excluding food and energy, prices rose 0.4% in April. That left the three-month annualized and twelve month rates tracking 5.1% and 5.5%, respectively, in line with analyst forecasts. While that’s still well-above the Fed’s target, this traditional measure of core inflation was boosted by highly volatile used car prices, which were up 4.4% in April alone. As a result, the reading on prices excluding food and energy overstates the trend in price growth.
Fed Chair Powell’s preferred gauge of underlying price pressures, core services excluding shelter, once again showed somewhat tamer price pressures. That stripped down measure rose 0.3% in April, leaving the three-month annualized rate unchanged at 4.0%. While that’s still a far cry from the Fed’s target for inflation, it gives the Fed more room to keep rates on hold at its upcoming meeting.
Treasury yields are falling after the release of the numbers. There’s a sense of relief that underlying price pressures aren’t reaccelerating despite the still historically tight labour market.
David Rosenberg, founder of Rosenberg Research
Rare has been the day that a pair of +0.4% readings on the headline CPI and the core index managed to generate such a positive response in the Treasury market (and by extension, equities). After all, it’s not as if the numbers came in below consensus views. Rather, they were right in line. What investors did very quickly was to assess the sector detail and realize that some very critical components that had acted as pervasive sources of upward price pressure are now reversing course; and that the stubborn areas like rents and used cars are complete statistical anomalies since we all know what is happening to both segments in real-time — as in, deflating. Strip out the rental measures and used vehicles, clear anomalies, and the core CPI index DEFLATED 0.1% MoM in April. So, put that in your pipe and smoke it! ...
What caused the headline numbers to come in at +0.4% was the fact that used vehicles saw a huge +4.4% price hike (this data is lagged just as the rents are), which was the sharpest run-up since June 2021. To underscore how bizarre this is, the last time new prices deflated this much, used vehicles followed suit with a -2.3% print. And we all know what the future holds (which is a reversal), because we all know that the Manheim index revealed a huge 3.1% slump in April. The shelter components are off the boil but are still influencing the headline and core numbers given that they command the highest weightings in the CPI — rents were up +0.5% MoM and OER (Owners’ Equivalent Rent) came in at +0.6%. Yet, we know that in seasonally-adjusted terms from the Apartment Listings data, that nationwide rents actually fell 0.5% in April. This is what the market realizes — that it is only a matter of time before the prior lagged effects in the CPI rent measures morph into present-day reality.
One last item: The Powell flavor du jour CPI metric, which is the services index that strips out energy services and both rental measures, came in at a mere +0.1% MoM. That is really encouraging! The weakest pulse since last July and second softest since September 2021. The YoY trend is still lofty at +5.1% but the uptrend line has been broken and this compares to +6.2% in January, +6.1% in February, +5.8% in March, and now +5.1% in April — but the three-month pace has slowed down nicely towards a +4.0% annual rate. And the momentum is clearly heading in the right direction for us disinflationists.
Andrew Hunter, deputy chief US economist, Capital Economics
The 0.4% m/m gains in headline and core consumer prices in April leaves core inflation at 5.5%, broadly unchanged from its level at the start of this year, further illustrating that the previous downward trend has stalled. We don’t think that will in itself be enough to convince the Fed to hike again at the June FOMC meeting but it does suggest a risk that rates will need to remain high for a little longer than we have assumed.
The rise in headline prices was supported by a 0.6% m/m rise in energy prices, as gasoline prices rebounded by 3%. The latest plunge in gasoline futures suggests that move will be more than reversed in May, however, and the earlier collapse in wholesale natural gas prices means that the 1.7% m/m fall in energy services prices in April won’t be the last monthly decline. As we had expected based on the producer price data, food at home prices also fell again last month, by 0.2% m/m, as the impact of earlier global supply chain problems continued to fade. ...
Despite a 0.2% fall in transport services prices, driven by a drop-back in airline fares, we calculate that prices for core services ex-housing rose by 0.4% m/m last month, up from a 0.3% gain in March. The lack of downward pressure on the latter remains a concern, particularly when it is the measure Fed officials are watching most closely. That said, as the easing in labour market conditions evident in the JOLTS and survey data starts to feed through, we still think core services inflation will start to ease more markedly soon.
Derek Holt, vice-president, Scotiabank Economics
Overall, I think the whole FOMC will look at the numbers differently than how the market did today and in a broader context with more data, developments and events ahead of us into the June FOMC. Most FOMC officials will focus on core that was still hot. I would caution against relying too heavily upon the market’s interpretation of the significance of the core services ex-energy and housing gauge.
While I think markets did react the way they did because of core services CPI, there are other less likely but still plausible reasons for some of the reaction. Perhaps markets were positioned for an even stronger print in line with the Cleveland nowcast that leaned closer toward 0.5% m/m core when we got 0.4% in which case it’s a positioning thing and not necessarily something that would be aligned with how the Fed would look at it. Or perhaps markets were looking at the one-tick miss on the headline y/y rate and the one-tick deceleration in the y/y core rate, neither of which are at all relevant in my view given the need to ignore disinflation driven by base-effects and to instead pay much closer attention to pricing power at the margin using m/m gauges
Karyne Charbonneau, executive director, economics, CIBC Capital Markets
Core inflation continued to advance at a steady, but still too hot, pace in April in the U.S., while higher prices at the pump meant that overall price pressures picked up momentum once again. .... Today’s data was in line with expectations and does not change our view that the Fed has now paused its interest rate hikes, but the still hot pace in core inflation also reaffirms that rate cuts are not in the cards for this year.
Sal Guatieri, senior economist, BMO Capital Markets
There’s a little something in the CPI report for both FOMC hawks and doves. The still meaty core price increase (with its 5.1% annualized 3-month rate) will dissuade any thoughts of near-term rate cuts. However, signs of cooler services inflation should support a rate pause in June, and, we suspect, the remainder of the year.
Thomas Feltmate, director and senior economist, TD Economics
There were definitely some encouraging signs in this morning’s CPI numbers. The continued deceleration in shelter costs suggests that we are starting to see some passthrough from last year’s pullback in rental rates, which should continue for the next several months. Meanwhile, price growth across non-housing services decelerated to its slowest month-on-month pace of growth in nearly two years.
That said, we need to balance this morning’s good news with the fact that goods prices have accelerated for a second consecutive month and have (again) become a source of inflationary pressure. And while the slowing in shelter costs is encouraging, more recent market-based measures of rent have shown that average rental costs have again turned higher and are already back to last year’s highs. This suggests the disinflationary pressure from shelter could be fleeting.
At the May interest rate announcement, the Fed signaled that they were nearing the end of its tightening cycle, but left the door open to further rate increases should the economic data continue to surprise to the upside. At this point, it’s still too early to say if another hike is in the cards, particularly given the uncertainties surrounding the recent tightening in lending standards and the potential knock-on effects it may have on the real economy. But one thing is for certain. Current market pricing, which shows rate cuts beginning as early as September, appear out of step with the recent flow of economic data. Any outward push on rate cut pricing should help to pressure yields higher, effectively doing some of the heavy lifting for the Fed.
Jocelyn Paquet, economist, National Bank Financial
The core services segment .... advanced at a lesser pace than core goods for the first time in 15 months. The deceleration in this segment reflected a relatively subdued increase in the cost of shelter. Recall that price movements in the housing sector are typically reflected in the CPI with a considerable lag. This means that the recent stagnation in house prices, and the stabilization in rent prices, is only now beginning to have an impact in the data. However, this impact should increase in the coming months and help limit the rise in the price of core services.
But aware of these peculiarities, the Fed is unlikely to put much weight on a deceleration in the price of core services if it is solely based on lagged components. Instead, the central bank will keep its eyes fixed on the prices of core services ex-housing as these afford a better idea of underlying inflation momentum. And the news on that front were quite encouraging in April. To be sure, prices in this crucial category rose only 0.1% m/m, the least since July last year. On a three-month annualized basis, they were up 4.1%. Although this is less than the 5.2% recorded in the prior month, this remains too high to offer much flexibility to the Fed. The latter is thus likely to maintain policy rates where they are for some time and wait to obtain more convincing evidence that inflation is converging with its 2% target before it feels confident enough to start cutting rates. In our view, this will only happen at the very end of the year, which is to say later than what markets currently anticipate.
Simon Harvey, Head of FX Analysis at Monex Europe (forex services firm)
Following Friday’s strong jobs report, pricing of the Fed’s policy path in US money markets had become a bit more sympathetic to the central bank’s “higher for longer” narrative as 21bps of cuts had been priced out of the December OIS [overnight index swap] contract. For traders to continue pushing back on expectations of an imminent and aggressive easing cycle, April’s inflation data needed to come in hotter than expected. However, with headline and core inflation both coming in at 0.4% MoM, prices developed as expected in April. Due to base effects, headline inflation printed at 4.9% YoY, a tenth below expectations, and the core measure printed in line with consensus at 5.5% YoY.
Not only did the aggregate figures not meet the threshold required for fewer rate cuts to be priced, but with 89% of the monthly increase in headline inflation generate by just shelter (+0.15pp), used cars (+0.11pp), and gasoline (+0.10pp), the details of the CPI report were also soft.
Following the release of the report, money markets priced out some chance of a Fed hike in June, lowering the estimate by 5pp to 10%, while 6bps worth of rate cuts were priced back into the December OIS contract. ... In light of today’s release, our confidence in the view that last week’s rate hike from the Fed was the last of this cycle has increased.
With a report from Reuters
Darcy Keith