For financial markets, summer has begun with a single piece of economic data setting off some fireworks. The news on 12 July that the pace of US inflation slowed by more than expected led to a sharp fall in bond yields and a rebound in equities – reversing what happened the previous week.
Good news on inflation
There’s no point rifling through all the indices, sub-indices and components of the consumer prices data. One chart (Exhibit 1, below) and a single sentence suffice to explain what happened: US inflation is finally slowing.
In June, headline inflation fell to 3.0% year-on-year from 4.0% in May, the lowest since March 2021. Core inflation (ex food and energy) fell from 5.3% to 4.8%, its lowest since October 2021.
The Beige Book, prepared by Regional Reserve Banks ahead of the US Federal Reserve’s (Fed’s) monetary policy meeting, provides qualitative insights. The report suggests that inflation has slowed and price expectations should remain generally stable (or even lower) over the next several months.
It appears that consumers in some districts are becoming more price sensitive, so businesses are reluctant to increase what they charge for their products and services. However, this is not all-embracing. In services, there is strong demand, allowing companies to maintain their margins. The coming earnings season will provide valuable insights on those margins.
Implications for monetary policy
The consensus view, which we share, is that the Fed is likely to raise its policy rates by 25bp at the Federal Open Market Committee (FOMC) meeting on 25/26 July, raising the federal funds target rate into the 5.25% -5.50% range. This has been widely priced in by markets, with a probability of over 90%.
Fed Chair Jerome Powell has insisted that the status quo on key rates in June was a pause, not the end of the tightening cycle. Indeed, the Minutes of the 13/14 June meeting confirmed that the pause was meant to give the FOMC time to consider the consequences of previous policy rate hikes, given that inflation remains unacceptably high and further rate hikes would be warranted.
If Powell continues to monitor the 6-month average change in the personal consumption expenditures (PCE) excluding food and energy deflator, it is likely that the level expected for June – at still above 4% – will not satisfy him, especially given strong employment data.
As expected, expectations for the next FOMC meetings changed after the latest inflation figures: The level of rates anticipated for the end of 2024 is now 40bp below the level of a week ago. Investors took a long time to come around to the idea that US policy rates would remain ‘higher for longer’ once the terminal rate was reached. This hypothesis – however well it may fit with comments from members of the FOMC – remains the subject of much discussion.
Beginning of a new phase?
June was marked by decisions and comments from many central banks that were more hawkish than expected, which led to significant rises in bond yields, especially those of shorter maturity bonds.
On 4 July, the Reserve Bank of Australia (RBA) left its policy rate unchanged – a surprise given expectations of a 25bp hike. The RBA said it wanted more time to judge the impact of previous increases (+400bp since May 2022), but its forward guidance still foresees that further hikes may be needed to ensure inflation returns to target within a ‘reasonable’ time horizon.
On 12 July, the Reserve Bank of New Zealand (RBNZ) also opted for the status quo at 5.5%, saying that monetary policy appeared sufficiently restrictive.
The same day, the Bank of Canada (BoC) raised its policy rate by 25bp to 5%. It said ‘underlying inflationary pressures are more entrenched than expected. Indeed, survey data from companies indicates that they are continuing to raise prices more often than normal.’
The BoC remains determined that its ‘job is not done’ until inflation returns to its 2% target. It will adopt a ‘meeting-by-meeting’ approach to its next decisions. The governor did say, however, that the committee ‘discussed the possibility of holding rates unchanged and gathering more information to confirm the need to raise the policy rate.’
Admitting to such hesitation so clearly is unusual among central bankers. We do not believe Jerome Powell will make such a confession at the end of the month. The Kansas City Fed symposium on Structural Shifts in the Global Economy in Jackson Hole on 24/26 August may be a better place for getting things off his chest.
In the meantime, investors will likely continue to dither and we could see erratic movements in equities, bonds and other assets, especially the foreign exchange market. The rapid fall in the US dollar and the rise in the yen after the US inflation data release may only be a foretaste of things to come.
Cautious on equities, more exposure to government bonds
Investors will have to get used to this new transitional phase. The lagging nature of some economic indicators (employment, in particular) tends to hide the reality of an impending slowdown. Arguably, inflation was indeed ‘transitory’, in the sense that central banks managed to slow it without weakening the labour market.
In recent weeks, investors have chosen to focus on the more favourable factors, including the (presumed) impending end of policy rate hikes, an inflexion in inflation and a dynamic labour market. This has contributed to the return of risk appetite, especially for equities, which have come sharply back into favour.
Positioning surveys reveal excesses, suggesting caution in the short term, all the more so given that some technical imbalances have been glossed over and the fact that the rise in US indices has been driven by a very small number of stocks.
These various factors encourage us to be cautious on equities in the short term, even when relative value positioning (sectors, geography) are taken into account.
The environment in the coming months prompts us to increase exposure to government bond markets, which we have done gradually in recent weeks. We reinforced this strategy last week as US 10-year government bond yields abruptly surpassed thresholds we had identified as offering buying opportunities.