Convincing Fall in U.S. Inflation

Convincing Fall in U.S. Inflation

The two-year Treasury yield dropped more than 12 basis points, falling from 4.62% to 4.50%, and the US dollar index hit a five-week low after the US CPI report revealed inflation slowed more than expected last month. Earlier in the week, Fed Chair Jerome Powell indicated that the central bank needed more confidence in the inflation slowdown before adjusting rates. This CPI report may provide that reassurance. Softer economic data in recent weeks have further fuelled concerns about a sudden US slowdown. Consequently, traders now anticipate up to 60 basis points of rate cuts this year, suggesting two definite cuts and a potential third. The dollar is naturally under pressure, with the 104 level on the DXY being a key support focus. If the US 2-year yield remains at 4.5%, it could limit further losses, but the bond market's expectation of more cuts extending into 2025 may keep the dollar under pressure.

In a surprising turn for many investors, major US equity indices saw a sharp decline, with the Nasdaq dropping 2%, marking its weakest day since mid-April. This is the worst reaction to an inflation disappointment since the Fed began raising rates in early 2022. One interpretation is that the market had already priced in much of the anticipated good news regarding Fed rate cuts. Alternatively, the market may not have adequately discounted easier policy, and the inflation report now provides the Fed with a mandate to cut rates. This shift has moved capital from the overbought tech sector into value and small-cap stocks, resulting in the Russell 2000 having its best week of the year so far.

The specific reason for the capital reallocation is less critical to our macro thesis and the declining US dollar. Inflation declined on a monthly basis for the first time since the pandemic. Persistent indicators like core, shelter, and services inflation continued to ease in June as the headline figure fell to 3.0%. Heading into the last day of the week, attention will turn to the producer price index, which is expected to increase from 2.2% to 2.3% in June. This aligns with our assumption of continued disinflation in the consumer sector while reflation in the industrial sector begins to build. This could pose a problem for the Fed in the future. For now, the market welcomes the news of lower inflation.

Sterling surged over a cent against the US dollar to $1.2949 yesterday, marking its highest level since July 2023 and surpassing its key 200-week moving average of $1.2850. If it closes the week above this level, it could trigger further gains. This climb was fuelled by hawkish comments from Bank of England (BoE) policymakers, stronger UK GDP data, and a softer US inflation report.

The pound has outperformed all its major peers this year due to expectations that the BoE will need to maintain interest rates at 16-year highs for an extended period, driven by a surprisingly robust economic recovery and persistent concerns about stubborn services inflation and wage pressures. The UK economy grew by 0.4% in May, double the expected rate, positioning Britain for another solid quarter of expansion after leading the G7 in GDP growth in Q1. While some central banks are already cutting rates, the BoE has suggested that an August rate cut may be unlikely as inflation is expected to rise again. Money markets currently predict about a 50% chance of a cut in August and 49 basis points of easing by the end of the year.

This outlook bodes well for the pound, which is also buoyed by optimism that the newly-elected Labour government will bring political stability and a prudent approach to national finances. Adding to the pound’s recent strength was data showing that US inflation cooled last month, increasing expectations of more Fed rate cuts this year and next.

 

Please note:  The news and information contained on this site should not be interpreted as advice or as a solicitation to offer to convert any currency or as a recommendation to trade.

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