Mixed news from the CPI release - but what does it mean for rate cuts?

Yesterday’s US CPI report delivered a few interesting numbers worth commenting on in our opinion. First of all, there was yet another upside surprise, the third in a row, in headline CPI inflation with the year-on-year figure coming in at 3.2% compared to market expectations of 3.1%. 

This cannot be good news at a time when central banks around the world are fighting inflation. The question is how bad a piece of news the report actually is. Answering the question requires delving a little bit into the detail, and once we did, we concluded the report is actually consistent with the Fed’s views of inflation declining slowly but surely towards target.

Inflation figures at the moment hide a tug of war between an increasingly light goods disinflation and a wage-and-rent-propelled services inflation. Core goods (i.e. goods excluding food and fuel) posted a 0.1% increase in February. This is the first monthly increase since May 2023 and was a negative surprise in our view. Although one data point does not necessarily mark the start of a new trend, it is definitely one worth watching. If core goods disinflation, which represents 25% of the core CPI basket, has in fact ended then we need services inflation to display a more encouraging trend in order for headline and core CPI to continue declining.

Fortunately, services inflation figures brought about some good news. Although the headline services inflation at 0.5% month-on-month is far from a level the Fed would consider consistent with inflation being at target, the underlying details were reasonably good. Shelter inflation is the largest component of the services inflation basket and has been the most talked about as it bears a close relationship with house prices, with a lag. Shelter inflation, at 0.4% month-on-month, was quite a bit lower than the 0.6% we witnessed last month. 

For the best part of the last 12 months this component has been hovering around the 0.4% to 0.6% range, so the fact that it fell towards the bottom of the recent range is good news. The ‘supercore’ inflation number also fell from the previous month. This comprises services excluding the aforementioned shelter components and is a more direct measure of the impact that wage inflation might be having in the CPI basket. This measure dropped from 0.8% month-on-month to 0.5%. Although there has been some progress in this measure, it is worth highlighting that these numbers are still inconsistent with the 2% target. 

We interpret this CPI release as one that is still consistent with the Fed’s goals and timelines. Some more volatile components, such as used cars, provided some upside to February’s CPI figures compared to market expectations, but it is true that the main ones that speak of the broader trends seem to continue to move in the right direction. We are not saying that this was a great report either. But we do not think Fed chair Jerome Powell would be less convinced that inflation is in fact moving towards the target after seeing this report. 

The US Treasury market sold off during the day, but price action was somewhat strange. There was an immediate sell-off in rates after the CPI numbers, but it reversed quickly before selling off again with the 10-year ending the day 6bps wider. There was an uninspiring 10-year auction in the afternoon as well with dealers taking the largest percentage allocation so far this year, which might have also provided some selling pressure. Our view is that after a decent rally, the news flow needs to outperform expectations for the rally to continue. Given the CPI number was slightly worse than expected, even if the detail was not as bad as the headline might have implied, there might have been some profit taking, which could extend a little bit further. 

Overall, the trends remain: inflation should continue declining albeit not in a straight line towards target, which should allow central banks to cut rates in the context of some sort of a soft landing. Given where yields are, and the likelihood that we will see some rate cuts this year, alongside avoiding a hard landing, we think fixed income markets are poised to deliver an attractive total return this year.