US CPI much higher than expected again. Yield curve initially flattens on Fed rate hike risk before weak 30-year auction drags long-end rates higher. Equity markets give back earlier gains as US 10-year rate jumps

US CPI released overnight was much higher than expected for the third month running, albeit boosted by some temporary factors like used cars.   The CPI release saw the market bring forward Fed rate hike expectations while a very weak 30-year US bond auction drove longer-term rates higher, with the US 10-year breaking above 1.40%.  Equity markets reversed earlier gains as the US 10-year started to climb.  The USD has experienced a broad-based appreciation and is trading near a 3-month high while the NZD has slipped back to around 0.6940, having earlier made a fresh year-to-date low.  The RBNZ Monetary Policy Review takes place this afternoon while Fed Chair Powell testifies to Congress tonight.

A much higher-than-expected US CPI release has been the focus in markets overnight.  Both headline and core inflation jumped 0.9% in the month of June, taking their year-on-year rates to 5.4% and 4.5% respectively which, for core inflation, is its highest annual rate of increase since the early 1990s.   A 10.5% increase in used car prices (on the month!) added 0.42% to June CPI on its own, accounting for almost half the increase in monthly inflation.  Used car prices are now some 45% higher than year-ago levels reflecting strong demand and supply disruption in the auto industry amidst a global shortage of semiconductors.  Core inflation excluding used cars is a more moderate 3.1% y/y.  But there were also signs of a pickup in inflation outside Covid-disrupted sectors, with shelter inflation, which accounts for more than 40% of the core index, increasing 0.5% on the month.

In a CNBC interview after the CPI data was released, San Francisco Fed President Daly played down the current spike in inflation as temporary, citing in particular “temporary bottlenecks” in used car prices.  However, Daly, who is thought to be one of the more dovish members of the committee, said it might still be appropriate for the Fed to start tapering its bond buying later this year or in early 2022.

The immediate market reaction to the CPI data saw US Treasury yields out to 5 years spike higher, with the market bringing forward its Fed rate hike expectations (the first 25bp increase is priced for late-2022).  In contrast, the US 10-year rate fell slightly, to 1.34%, with the market seemingly of the view that if the Fed were to tighten earlier, it won’t need to tighten by as much and inflation expectations won’t run away.

But the long-end of the rates market turned around after a very weak auction of 30-year US Treasury bonds, which were issued 2bps above prevailing secondary market levels, indicating investor resistance to buying long-term bonds at these low yield levels.  The US 10-year rate promptly jumped up to 1.41%, now 5bps higher on the day, with the yield curve reversing its earlier flattening.  The yield on the Australian 10-year bond future has increased 5bps since the local market close, suggesting NZ rates are likely to open higher in response this morning.

Long-term market-based inflation expectations haven’t moved much, implying continued market belief that the Fed will won’t let inflation run away.  Despite an 8bp jump in 5-year inflation expectations, to 2.59%, The 5-year 5-year forward ‘breakeven inflation’ rate is little changed overnight, at around 2.15%, a level broadly consistent with the Fed’s 2% target for PCE inflation.

US stocks are down modestly overnight, with both the S&P500 and NASDAQ off around 0.3% while the Russell 2000 index of small cap stocks is down 1.5%.  The NASDAQ was up 0.5% at one point, a fresh record high, before giving back those gains as the US 10-year rate jumped above 1.40%.  Judging by the immediate reaction to the CPI release, the stock market narrative around inflation seems to be shifting.  Previously, the market thought higher inflation would boost cyclical stocks like banks and energy producers and harm the valuation of tech stocks which are more reliant on longer-term earnings.  The immediate market reaction to CPI suggests the market now sees higher inflation as increasing the chances the Fed will need to respond earlier with rate rises, capping both economic growth (and those stocks more cyclically exposed to growth) and long-term rates (which helps tech stocks).

The USD has experienced a broad-based appreciation on the back of the upside surprise to CPI and the bringing forward of Fed rate hike expectations.  The BBDXY index is up 0.5%, taking it back near the top of its recent range and close to a 3-month high.  The EUR has fallen below 1.18 (-0.7%) and is trading at its lowest level since the start of April.  The NZD and AUD are down 0.6% and 0.4% respectively.  The NZD made a fresh year-to-date low in the immediate aftermath of the US CPI release, around 0.6920, although it has recovered slightly, to trade this morning around 0.6940.

Corporate earnings season in the US has kicked off with JP Morgan reporting stronger-than-expected earnings and revenue numbers overnight, although the result was flattered by the release of loan loss reserves.  The flatter US yield curve and glut of deposits restrained net interest margins in the quarter.  Goldman also reported better-than-expected earnings, boosted by investment banking revenue on the back of a surge in new listings.  Both banks saw their share prices fall around 1% overnight.  Meanwhile, PepsiCo jumped 2% after reporting stronger than expected earnings and raising its forecasts, as people head back to restaurants with economies reopening.

Turning to domestic developments, we refined our NZ Q2 CPI forecast, which is released on Friday, after yesterday’s release of food prices and rents.  We still look for a 0.7% quarterly increase in headline CPI, but our year-on-year forecast now rounds up to 2.8% (the RBNZ is at 0.6% and 2.6% respectively). We continue to see CPI risks generally to the upside.  To be sure, it is the second half of 2021 where more divergence with the RBNZ appears. We see annual inflation lifting to 3.3% and 3.4% in Q3 and Q4, above the top of the RBNZ’s 1-3% target range, compared to the RBNZ’s May MPS forecasts of 2.5% and 2.2% respectively.

Yesterday’s REINZ data painted a picture of a housing market that was still going strong, despite the raft of government policy announcements earlier this year which were aimed at dampening investor demand.  Sales were the strongest for a June in five years while days to sell and inventory for sale remained very low.  House price inflation over the past 12 months to June was a staggering 29.8%.

Yesterday was a quiet day in the domestic rates market (2 and 10-year swap rates +1bp) as traders waited on today’s RBNZ Monetary Policy Review.  The RBNZ will need to acknowledge the undeniable strength in domestic data and will likely drop its reference to “considerable time and patience”.  But with already heightened expectations for a rate hike over the next six months (he market is pricing around an 80% chance of a November OCR hike and non-negligible 25% chance of a move at the next meeting in August), the hurdle for a hawkish surprise may now be reasonably high.  We expect the RBNZ to end its bond buying in the coming months, with an announcement on that front even possible as soon as today.

Fed Chair Powell will testify in front of Congress tonight, with the market on the lookout for any clues around the possible timing of tapering.  Powell is almost certain to be grilled by Republicans on inflation.   The Bank of Canada also has its policy meeting tonight and is expected to further taper its bond buying, from $3b/week to $2b/week.  The Bank of Canada is expected to be one of the first central banks to raise its cash rate (the market prices the first hike in Q2 next year), with the anticipated tapering of its bond buying a step in that direction.