US inflation makes case for (small) September rate cut

Wednesday’s US Consumer Price Index (CPI) inflation data brought good news for investors and central banks.

After recent volatility markets have enjoyed a few days of nervous calm, which we would wager could have been easily disturbed by data surprises to the upside or the downside. Fortunately, US inflation avoided either. Headline and core inflation for July came at 0.2% month-on-month, resulting in 2.9% and 3.2% year-on-year figures respectively. Almost all were in line with expectations, with headline only slightly lower than expected. While a larger than expected decline in core goods inflation was a notable positive detail in the report, it did also contain some minor negatives. Chief among these was an increase in core services inflation caused by the dreaded shelter component. Rents and owners’ equivalent rents inflation accelerated month-on-month, pushing core services inflation to 0.31% month-on-month, its highest reading since April.

Despite these less encouraging details, we do believe this set of numbers solidifies the case for a September rate cut from the Federal Reserve (Fed). The odds of a 50bp cut have decreased though; a lot would be needed for the Fed to start its cutting cycle with a big bang, and an in-line CPI report wouldn’t seem to be enough. Data remains notoriously difficult to predict and markets remain on alert after recent swings, so we cannot rule it out. But those advocating for such a move certainly have less ammo to defend their rationale after this report, especially considering most of the panicked price action has reversed in the last few days.

As we write this piece, the reaction in US Treasury markets is for slightly lower yields including a mild change in the shape of the curve; the two-year yield is unchanged while the 10-year yield is down 3bp. Our reading of this is that, after the substantial rally from roughly 4.2% that begun in late July, the curve is now pricing in several rate cuts already. At the moment, the curve incorporates a terminal rate (the lowest a central bank takes rates in a cutting cycle) of 3.04% in three years’ time. This isn’t far from the level markets were pricing in at the beginning of the year. For a meaningful rally in the 10-year Treasury from these levels, we think markets would need to see evidence of a proper recession in the data. Inflation slowly moving towards target and the Fed embarking on a cutting cycle will not be enough to drive yields significantly lower from here. That doesn’t make us bearish on Treasuries, since still serve as insurance against the risk of a recession actually arriving. But in the absence of increasingly negative labour and growth data, we don’t think 10-year Treasuries have a lot further to go.

The labour market report published on August 2 was a bad one. A negative surprise in unemployment, at a time when the labour market is as critical as it is now, increases the chances of recession at the margin. Nevertheless, our base case is that growth will continue to weaken and will be below potential growth for a quarter or two, but that a recession will be avoided. It is a slippery slope and things can change quickly, therefore we remain on high alert and ready to change allocations rapidly if needed. That said, we would expect credit to resume its outperformance of government bonds.