Boosted market expectations of Fed rate cuts led to falls in US rates and a steepening of the yield curve; there was only a short-lived positive impact on equities; USD has also strengthened

Boosted market expectations of Fed rate cuts led to falls in US rates and a steepening of the yield curve; there was only a short-lived positive impact on equities; USD has also strengthened

A lower than expected US core CPI release overnight boosted market expectations of Fed rate cuts and led to falls in US rates and a steepening of the yield curve.  There was only a short-lived positive impact on equities from the CPI release however, with the S&P500 now slightly lower on the day.  The USD has also strengthened, despite the miss on US CPI. 

Market pricing for a July rate cut by the Federal Reserve is now up to 94% after US core CPI missed expectations overnight (2.1% vs. 2.2% expected).  Used car prices, which have been a significant drag on core inflation over the past few months, fell again (-1.4% m/m) while inflation in the heavily-weighted shelter category rose at a slower pace than its recent run-rate.  While the likes of used car and apparel prices have weighed on core inflation in recent months, leading Chair Powell to conclude at the last Fed meeting that “transitory factors” were at play, the current level of core inflation is unlikely to be seen as a barrier to rate cuts.  The focus at the upcoming FOMC meeting on June 20th will be whether or not the Fed removes its reference to being “patient” with interest rates.  The market is likely to interpret the removal of that phrase as signalling an imminent Fed rate cut. 

The short-end of the US yield curve was most impacted by the CPI release, with the 2 year Treasury yield down 5bps to 1.89%.  The market now prices around 2½ rate cuts by the Fed by the end of the year.  Longer-dated Treasury yields lagged the moves (indeed, the 30 year yield is actually marginally higher on the day), with the yield curve steepening in anticipation of Fed easing. 

Ordinarily, we might have expected a major boost to US equities from the lower CPI release and increased market conviction of Fed easing.  But the positive impact was short-lived, and all three major US equities indices are down slightly as we write (S&P500 -0.2%, NASDAQ -0.3%).  The lack of reaction in equities probably reflects some consolidation after their recent strong run and lingering concerns around the US-China trade war.  Market sentiment remains shaky ahead of the expected meeting between Trump and Xi at the G20 later this month, given the threat Trump could impose 25% tariffs on the remaining $325b of Chinese imports if a ceasefire can’t be agreed. 

In terms of sector performance, the energy sector led losses on the S&P500 (-1.5%) after a chunky 3.5% fall in WTI crude.  The weekly DOE report revealed a surprise increase in crude oil inventories for the second week running, and oil prices have fallen close to their lowest levels since January.  Financials also underperformed (-0.8%), with the prospect of Fed rate cuts perceived as likely to erode net interest margins for banks.  Defensive sectors outperformed, led by utilities. 

Like equity markets, there was only a fleeting impact from the US CPI release on the USD.  The DXY and BBDXY are actually higher on the day, both by around 0.3%. 

The EUR reached a high of 1.1340 – close to its highest level since late March – in the immediate aftermath of the CPI release.  But it has since fallen away to 1.1285 after Trump threatened to impose sanctions if Germany went ahead with the Nord Stream 2 gas pipeline from Russia. 

The GBP fell 0.3% after parliament rejected Labour’s cross-party motion intended to prevent a no-deal Brexit (by 308 to 298).  But we should expect further motions from MPs in the coming months, seeking to take control of parliamentary process in order to prevent a no-deal exit, especially if the next Prime Minister makes a red line of leaving on the 31st October. 

The AUD is the weakest of the G10 currencies overnight and is down 0.5% to 0.6930.  The key Australian labour market report is released today, and our NAB colleagues look for an above-consensus 40k increase in jobs in May (boosted by hiring for the election) and a tick-down in the unemployment rate to 5.1%.  That would still leave the unemployment rate well above the RBA’s latest estimate of NAIRU of 4.5%.  We note that RBA Assistant Governor Luci Ellis yesterday raised the possibility that NAIRU could be even lower than 4.5%. 

After underperforming the previous two sessions, the NZD has held up better overnight.  The NZD is down a modest 0.15% to 0.6570, despite the broad-based USD strength.  The NZD/AUD cross has nudged up to just below 0.95. 


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