US Inflation Surprised to the Upside – What Next?
This month’s most important economic data release was arguably yesterday’s US CPI, and it surprised to the upside.
We have already recently written about central banks HERE, HERE, and HERE , and we’ve discussed how markets are furiously trying to understand where the current tightening cycle will end.
CPI pulled back from 6.5% to 6.4% YoY, which was 0.2% higher than expectations. What are the market implications following this number and how do we see price action going forward?
The main takeaway is that although CPI (on a YoY basis) has been dropping for 7 months in a row now, the pace of the drop has declined almost to a standstill. This reading will now place even more pressure on the Federal Reserve to delay the end of this hiking cycle, and potentially it could force them to stay “higher for longer”.
This is firmly in contrast to what markets are pricing. Fed Fund futures now looking for almost three more 25bp hikes in 2023, but more importantly we are pricing almost 50bp of cuts by the end of Q1 2024. The 10y US Treasury yield has barely moved following the CPI release, currently at 3.75%; the curve is still very inverted, a phenomenon that almost always points to a coming recession. From a technical standpoint the 10y yield has broken out and is looking like it could be preparing for an assault towards the 4% mark or even the previous high at 4.33%.
This tug-of-war between the Federal Reserve and the markets has been ongoing for weeks, and at some point something’s gotta give. Jay Powell has been on the hawkish side for a while now, making it clear that the Fed’s primary goal is to bring inflation back down to target. The pace of rate hikes has now slowed down to 25bp increments, but there is a clear risk to the upside if inflation remains stubbornly high.
On a macro level it now seems relatively clear that the market risk is firmly to the downside. Financial conditions have tightened significantly, and we could well see a lot more before the current cycle is over. Tighter conditions usually mean weakness in bonds and equities, as high yields decrease risk appetite and borrowing ability. It’s reasonable to expect one more leg lower in risk, at least until we see inflation picking up pace to the downside again.
In this scenario, the US Dollar should be one of the main beneficiaries, as risk-off is usually followed by USD strength. Following the US CPI data release, the DXY has been on both sides of the bull flag pattern “flag” but still under channel resistance which is at 103.65. A break of this level would breach the 61.8% Fibonacci retracement of the last major leg lower (January 6th highs to February 2nd lows) at 103.83 but also the channel resistance which has capped the US Dollar since November of 2022.
To summarise, both the macro and the short-term technical viewpoints point towards a risk-off move in the coming days and weeks, and equity & bond bulls should be aware of that. Cryptos, precious metals and other commodities should also underperform in a knee-jerk reaction as risk moves lower, but in the medium term the prevailing high inflation environment should see them recover.
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