CPI and FOMC post mortem

Yesterday was an eventful day to say the least for financial markets. Consumer Price Index (CPI) inflation as an entrée was well received by the diners, prompting a 15 basis points (bps) rally in the 10-year Treasury. The main course though, was met with some adverse critiques as the Federal Open Market Committee (FOMC) delivered a slightly more hawkish dot plot than expected. The main chef, Powell, did not push back on people’s reviews and sounded quite balanced in the press conference, a bit of a contrast with previous press conferences where he sounded a bit more dovish than the statements and projections might have implied. US Treasuries, consequently, gave back some of their gains.

CPI inflation data was undoubtedly positive. Both headline and core numbers were 10bps lower than expected in their month-on-month (MoM) and year-on-year measures (YoY) measures. Core inflation at 3.4% YoY represents the lowest print since April 2021. Regarding the MoM number, in the second half of 2023 there were four out of six releases that came at 0.2% with the remaining two at 0.3%. In 2024 however, we had three 0.4% MoM core inflation prints in a row from January to March followed by a 0.3% print in April. Certainly, this latest print at 0.2% is good news albeit it is only one data point. Looking into the detail, energy inflation was -2.0% MoM which pushed down the headline number. More importantly though, there was a marked decline in the MoM core services measure, which includes rents, from 0.41% to 0.22%. This is a positive development as it is here that wage pressures show up most prominently. While we would have liked to see the shelter inflation number declining somewhat, our favourable read of the numbers is not altered by an unchanged 0.4% MoM figure in this category. Core goods continued to slowly creep higher from negative territory to 0% MoM which highlights just how important it is for services to continue moving in the right direction for disinflationary trends to continue materialising.

Moving on to the FOMC meeting, the main market mover were the changes to the dot plots. Monetary policy rates were left unchanged as widely expected, but the median dot for 2024 now shows only one cut, down from three in the previous dot plot. Most investors were expecting a revision in this direction but maybe not such a big majority were expecting it to move to one cut for 2024. On the other hand, inflation projections moved higher partly reflecting higher than expected numbers since the previous release. Personal Consumption Expenditures (PCE) inflation median forecast moved from 2.6% to 2.8% for 2024 and from 2.2% to 2.3% in 2025, while the 2026 projection was left unchanged at 2.0%. Analogously, median monetary policy rate projections moved slightly higher in 2025 from 3.9% to 4.1%, while for 2026 the number stayed at 3.1%. Lastly, the longer run median monetary policy rate expectation increased from 2.562% to 2.75%, with nine out nineteen members forecasting this variable to be at 3% or above.

Our read of these events is that the path inflation will follow towards central banks’ targets will continue to be bumpy. Visibility is lower compared to previous cycles given the higher uncertainty that’s associated to macro forecasts at the moment. What is most important to us though, is that the median FOMC member sees the higher inflation prints we have witnessed so far this year mostly as a delay in inflation moving back to target rather than an abrupt change in the macro environment. Consequently, the median FOMC member does not expect less rate cuts than previously, but the expectation is for cuts to take more time to materialise. As we argued in a blog last February, if deviations from central banks inflation projections are perceived as temporary with the end result being roughly the same, then we should not see a completely new range for the longer end of the curve. Volatility would no doubt remain high, as has been the case, in the context of central banks being fully data dependant, but ranges should hold. The longer-term rate projection moving slowly but surely upwards was to be expected. Time will tell, but this might have more to do with how low this parameter was in the previous cycle post GFC rather than with significant and permanent structural changes due to Covid.

Regarding positioning, in the context of a diversified fixed income portfolio, we continue to believe that having a position in rates looks like an unexpensive insurance policy for a non-base case of a harder landing. The level of uncertainty remains high and the price of said policy at 4.3% yields for 10-year Treasuries looks reasonable to us, albeit we are probably closer to a level at which it starts to look a little bit expensive. Having said that, most of future returns in our base case are not coming from a rally in rates but from the very attractive income levels on offer. Credit provides more income than government bonds as one would expect, and in our base case of some sort of soft landing in the US with a mild acceleration in growth already occurring in Europe and the UK, we remain advocates of having more credit (particularly in pockets of the market that still look good value such as financials and ABS) than government bonds exposures.