Source: AFP
Source: AFP
Overnight, financial markets surged after October’s consumer price index (CPI) report showed signs US inflation may finally be cooling.
Consumer prices rose 0.4% last month, below expectations. This lowered headline inflation from 8.2% to 7.7%. Excluding food and energy, core prices also advanced more slowly by 0.3%. This led to core inflation easing from 40-year highs of 6.6% in September to 6.3% in October.
US inflation remains far above the Federal Reserve’s 2% target. But October’s data was encouraging. As the pandemic recedes and supply disruptions ease, good prices are falling. Last month used car prices plunged 2.4%.
Cooling inflation will allow the Federal Reserve to reduce its pace of interest rate rises. Having increased its fed funds rate 75bps for four meetings in a row to 3.75-4.00%, we expect the Fed will now hike by 50bps in December.
Overnight, Fed Presidents Logan, Daly, Mester, Harker and George all signalled the Fed could slow its rate hikes to 50bps moves now. But officials still warned that inflation would require interest rates to increase further to restrict activity. We expect the Fed will lift its fed funds rate again in February by 50bps so that its key interest rate peaks at 4.75-5.00% in early 2023. Thus, while the CPI data gives hope that US inflation is finally cooling, the Fed will still want to see more evidence before ending its rate hikes.
Source: Bloomberg, Bank of Singapore.
In particular, the US labour market remains tight with wages growing almost 5%. October’s CPI report was also flattered by medical costs falling 0.6% after estimates of health insurance were updated. Rents, a more persistent source of inflation, remained strong with owners’ equivalent rent up almost 7% compared to a year ago as the chart shows.
The Fed will therefore want to see further monthly reports on inflation and employment before concluding it can stop raising interest rates. This will have the following implications:
Firstly, risk assets may trade firmer ahead of December’s Fed meeting. But November’s payrolls and CPI reports released before the Fed meets will determine whether it can shift to 50bps hikes now. Thus, investors should still be cautious of negative surprises as Fed officials will be.
Secondly, the strong USD may finally be peaking if the Fed cycle nears its end. Investors should turn more neutral near term as risks are balanced now between extended Fed hikes supporting the USD still and an end to the cycle causing USD bulls to take profits.
Lastly, we reiterate our view that Fed tightening this year will cause 10Y Treasury yields to peak around 4.00% and head lower to 3.50% next year. This will benefit high-quality, developed market investment grade bonds that act as safe-haven hedges against the risks of recession.
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