USD Rates: CPI hurdle cleared
The market cleared the US CPI hurdle smoothly, driving UST yields lower across the board. Headline CPI generally matched expectations, coming in at 0.4% MoM (consensus: 0.4%) and 4.9% YoY (consensus: 5.0%) reinforcing our view that the Fed is done in the current cycle.Under the hood, there are encouraging signs that inflation may finally be curbed. First, CPI core services less rent fell to 4% on a 3m annualized basis. This is one of the preferred measures of underlying inflation and it has come down from 9% about a year ago. Second, the shelter component of CPI (which has been a key driver of core inflation) is finally moderating. This measure tends to lag and we think that a sustained downtrend may be in place in the coming months, allowing both core and headline CPI to continue moderating. Judging from inflation swaps, CPI might well dip below 3% by the end of the year.
Market pricing for Fed cuts this year is understandable but the timing and magnitude of cuts remain debatable. The market is pricing in 3 cuts by the end of the year with near certainty (90%) that the first cut will get delivered in September. There are several ways to look at this. If CPI falls to 3% and the Fed keeps the policy rate at 5.25%, the real policy rate would be at 2.25%, extremely restrictive by any measure. If the market believes inflation will fall sustainably to those levels (as seen by breakevens), then some cuts would be warranted by year end, assuming no financial system shock. It might take several low CPI prints before the Fed is willing to relent. The market is roughly betting on three consecutive CPI prints around the 3% handle in speculating for a September cut. However, we should also consider the labour market. While there are some signs of cooling off, an unemployment rate of 3.4% does not point to an imminent recession. If the labour market does not materially weaken in the coming months, the Fed might not face the urgency to cut rates that soon. We are not as convinced of the one fully priced cut in September and see this as probably too dovish.
In any case, US Treasury yields are still stuck firmly in range. With CPI out of the way and the most recent set of numbers indicating that imminent bank failures have been averted for now,the focus should shift back to the debt ceiling. Considerable stress is showing up in T bills. However, this concern does not appear to be shared by other asset classes. The coming few weeks would likely be volatile until a resolution is reached with market participants attentive to an X-date as early as 1st June.
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