What's instore for the CPI release?

The most important event this week is likely to be this Wednesday’s US Consumer Prices Index (CPI) release. Expectations are for headline to come in at 0.4% month-on-month and 3.4% year-on-year, while core inflation is forecasted to land at 0.3% month-on-month resulting in a 3.6% year-on-year print. All four of these numbers are slightly too high vis-a-vis the Federal Reserve’s (Fed’s) 2% target. If the actual numbers come at these levels, then it would confirm that inflation continues to move at a lethargic pace and that progress has indeed plateaued. This is of course not what Fed officials would like to see. In addition to this, last week the US Michigan inflation expectations survey showed an increase in the one-year inflation expectations number for the second month in a row, and yesterday the New York Fed one-year inflations expectations number came in at 3.26%, up from 3.00% last month.

Despite this somewhat gloomy account, US Treasuries have not reversed the close to 20 bps rally that started in late April. The 10-year Treasury has hovered around 4.50% for the past week, which some might find surprising given that we have not had particularly encouraging news flow when it comes to inflation in the last few days. The reason for this might be in what the curve is already discounting. Looking at the interest rate probabilities function in Bloomberg, we see that the market is currently pricing in just over “one and a half” 25 bps rate cuts for year-end. This is a far cry from the seven rate cuts that markets were pricing in at the beginning of the year. It also represents the first time in a while that the market has moved ahead of the Fed, in the sense that it is likely that June’s dot plot will show the median rate cut number for 2024 moving from three rate cuts to two. It is also possible that we will see increases in the neutral rate level, but this is also something that most market participants would expect by now.

Considering the aforementioned points, we believe that if the CPI numbers come in line with expectations, despite these being elevated in the context of the Fed’s 2% target, they won’t move the dial too much for US Treasuries. No doubt there will be intraday volatility on the day, but we think it would take an outsized surprise either way to move US Treasury yields out of their current range.

There might be one exception though. If inflation comes in line with expectations but the detail shows a deterioration in services inflation while goods continue to trend lower, then Treasuries might sell off. The Fed needs to see housing inflation and services inflation, in general, picking up the disinflationary baton from goods for headline numbers to continue declining towards the Fed’s target in a sustainable manner. Goods inflation is already at pre-pandemic levels, so, there is not a lot of room for this component to keep on leading the charge.

Housing inflation is related to a number of factors and most of them have contributed to the rise in rents. The most important one has been the rally in residential property prices, but we also have to mention; high interest rates that make it more difficult for buyers, a depressed construction market, and more restrictive lending standards by the banking sector. Some of these factors are showing more encouraging trends such as the recovery in existing home sales and a slight improvement in lending standards. But, on the other hand, house prices are rising again. We will see what tomorrow’s report brings but the last few prints were not particularly encouraging.

Regarding services inflation, excluding housing, one of the main drivers is wage inflation. Services companies typically derive a large portion of their costs from wages, and therefore, it is difficult to see this component improving significantly unless wage inflation recedes. This is occurring with Average Hourly Earnings (AHE) growing at pre-pandemic month-over-month levels in the last couple of readings. Although these numbers are not yet sufficient to be called a trend, data is nevertheless encouraging.

Headline and core numbers are the most important ones in Wednesday’s release. But the devil might be in the detail!