US CPI inflation cracks 5% mark and ECB policy update on the dovish side of expectations. Market prepared to back Fed's view that inflation will prove transitory, so Treasury yields drift lower

The market was unperturbed by another shockingly high US CPI print, with the S&P500 reaching a fresh record high and the US 10-year rate pushing down to a fresh three-month low. The USD is broadly weaker overnight, but currency moves have been modest, with the NZD back to around 0.72.

“Super Thursday”, with much anticipation around the US CPI print and ECB policy update, turned out to be a non-event with market reaction to both events well contained.

For the third successive month, US CPI figures surprised to the upside, with annual headline inflation cracking the 5% mark in May and the core CPI rising by 3.8% y/y, the strongest underlying inflation in just under thirty years. The monthly gain in the core rate of 0.7% in May followed the 0.9% gain in April. But muting market reaction, strong inflation was once again driven by components related to the reopening of the economy, with used vehicles, car rentals, and airfares seeing further large price increases.

Another measure of core inflation – the Cleveland Fed’s trimmed mean measure – saw another small increase in underlying inflationary pressure, but at a more moderate pace than the official measures, with a monthly gain of 0.39% (previously 0.37%) and annual inflation rising to 2.6%.

Today’s stronger data says nothing about whether or not inflation will prove to be transitory and, given the breakdown, the market reaction was well-contained. After an algo-driven 4bps rise in the US 10-year rate to just over 1.53%, the yield has fallen back down and printed a fresh three-month low of 1.46%, down 3bps for the day. Based on the recent price action, the market is increasingly backing the Fed’s view that high inflation will prove transitory and therefore will be very slow to remove the current level of policy stimulus. This strategy is not without risk, given that it is clear that the economy no longer needs such an emergency level of monetary support, and the risk of over-heating looks to be growing. Focus now turns to the Fed’s policy update in a week’s time.

US jobless claims fell for a sixth consecutive week to 376k, consistent with the range of other labour market indicators showing an improvement as the economic recovery takes holds.

In its policy update, the ECB raised GDP growth and inflation forecasts and, for the first time since 2018, noted that the risks to economic growth are now balanced (previously saw downside risk). However, the Bank saw higher inflation as temporary (CPI inflation of 1.9% in 2021 but falling to 1.5% next year) and underlying price pressures remaining subdued.

On its QE programme the ECB still decided that emergency bond buying would continue at a significantly higher pace than seen at the start of the year. President Lagarde noted some diverging views on the Governing Council on the pace of bond purchases and some in the market had expected some moderation. So this was a small dovish surprise but overall market reaction to the ECB’s messaging was minimal.

The lower yield backdrop, and expectations of this to continue for some time, has supported the US equity market, with the S&P500 reaching a fresh record high and currently up 0.5% for the day. Oil prices showed some volatility. The US lifted sanctions on more than a dozen former Iranian officials and energy firms, ahead of further US-Iran nuclear negotiations. This saw oil prices plunge by over 2%, but the move quickly retraced and prices show modest gains for the day, with Brent crude at about USD72.50 a barrel.

In currency markets, lower US yields have been matched with a lower USD, although with only small changes evident. The dovish ECB has held back EUR performance, seeing it flat at 1.2175 while GBP has been the best performer, up 0.4% to 1.4170. The NZD and AUD both show modest gains to 0.72 and 0.7755 respectively and NZD/AUD flat at 0.9285.

The domestic rates market was influenced by global bond tailwinds, seeing some curve flattening and longer term NZGB and swap rates down in the order of 5-8bps. The 10-year NZGB rate closed at 1.69%, down about 10bps over the past week and about 20bps over the past two weeks.

NZ electronic card transactions rose by 2.3% in May, a very strong result on the back of the (revised higher) 4.4% gain in April and 2.0% gain in March. The data sets the scene for another strong quarter, following a solid Q1. It makes you wonder the logic of the RBNZ trying to stoke up domestic demand even further with its policy stance, particularly against the backdrop of significant supply-side constraints.

In the day ahead, NZ’s manufacturing PMI is released ahead of UK monthly activity data tonight (GDP, industrial production amongst others) and US consumer sentiment and inflation expectations data.