US rates finally correct lower after core CPI surprises to the downside. Market still priced for a 50bps Fed hike next month but expectations for tightening later this year scaled back

It’s been another volatile trading session overnight.  US rates have fallen sharply after US core CPI surprised to the downside.  The US 10-year rate is back to 2.72%, having traded as high as 2.83% yesterday afternoon.  After opening higher, US equities are now lower on the day, despite speculation China could start easing lockdown restrictions.  The NZD and AUD are stronger on the back of higher commodity prices.  The RBNZ MPR takes place today with the market pricing around an 80% chance of a 50bps OCR hike.

US headline CPI rose 1.2% in March, in-line with expectations, with the annual rate hitting a more than 40-year high of 8.5% y/y.  Headline inflation was boosted by an 18.3% monthly increase in gas prices (due to the Ukraine war) and a 1% rise in food prices.  But the market’s attention was focused on the downside surprise to core inflation, which rose ‘only’ 0.3% on the month, below the 0.5% consensus.

The key reason for the downside surprise in core inflation was a 3.8% monthly fall in used car prices, which shaved 0.17% off monthly core inflation.  Used car prices exploded higher during the pandemic (prices are still up some 35% on a year ago) due to production issues related to a shortage of semiconductors, but there are signs this is now starting to reverse.  On the other side of the ledger, shelter inflation, which accounts for around 40% of core CPI and is made up of rent and so-called ‘owner’s equivalent rent’, was up 0.5% for the second month in a row.  Leading indicators suggest shelter inflation will remain a persistent inflationary force this year.

Base effects mean that annual inflation should start to moderate from April onwards.  That said, with core inflation still running at around a 4% annualised rate (and wage inflation, on the Atlanta Fed’s measure, around 6% y/y), there will need to be a further easing in inflationary pressure to be consistent with the Fed’s 2% inflation target.  The CPI data provide some tentative signs that some of the pandemic-related price pressures might be starting to ease.

The Fed is still widely expected to raise its cash rate by 50bps next month, with futures implying around a 95% chance of such a move.  However, the CPI data saw the market temper its Fed rate hike expectations for later this year.  There is now around 208bps of rate hikes priced by year-end, down from 220bps yesterday.  The US 2-year rate is 12bps lower while the 10-year rate, which had pushed as high as 2.83% during Asian trading yesterday, is back to 2.72%, now 6bps lower on the day.  After an enormous sell-off over recent months, the bond market was arguably overdue for a correction.

US equity markets opened higher, presumably on hopes the CPI data might allow for a somewhat less aggressive pace of Fed tightening.  But they have since given back their gains, the S&P500 and NASDAQ are now both down by around 0.5%.

Oil prices have rallied 6% overnight, with Brent crude futures pushing back above $100, with the move partly attributed to speculation China could start to dial back restrictions.  Bloomberg reported that China’s focus was on Covid cases in the community, rather than in isolation, which, according to the authorities, was just 3% of the 20,000+ daily cases in Shanghai.  Earlier in the week, residents of some housing complexes were allowed to leave home, the first signs of an easing in lockdown restrictions, even as most of the city remains under stay-at-home orders.  Chinese Premier Li Keqiang reiterated that policymakers would take measures to support the economy, with investors expecting cuts to interest rates and reserve ratio requirements in the coming months.  China’s CSI300 equity index outperformed, rising almost 2% yesterday.  Other commodity prices have also risen, with copper increasing 1.4% overnight.

A stronger commodity backdrop and some increased optimism around China has seen the NZD and AUD outperform over the past 24 hours.  Both currencies are around 0.5% higher than this time yesterday, with the NZD trading this morning around 0.6865.

The NZD and AUD moves stand in contrast to the weakness in the EUR, which has fallen 0.5% to near a two-year low (around 1.0830 this morning).    Weighing on sentiment towards the EUR, Putin described peace talks with Ukraine as having reached a “dead end” and said Russia would continue with its “military operation”, seemingly quashing hopes for a near-term agreement.  The fall in US rates has seen the USD/JPY uptrend stall, as it consolidates just above the 125 mark.

In other economic data, the US NFIB small business survey showed confidence falling to a post-pandemic low of 93.2 while, less encouragingly for the inflation outlook, a record 72% of businesses reported raising prices.  It was a similar message in the German ZEW survey where expectations are close to their lowest on record.  In the UK, the unemployment rate dropped 0.1% to 3.8%, near its lowest level since the mid-1970s.

In Australia, the NAB Survey showed business conditions and confidence soaring further, and cost pressures at the highest in the history of the survey (post 1997 for the monthly version of the survey).  The market is pricing just over 200bps of rate hikes by the RBA by the end of the year.

Turning to local developments, yesterday’s QSBO business survey showed an unsurprising combination of extremely elevated inflation and cost pressures, intense skills shortages, and dwindling profit expectations.  Highlighting the mixed picture, domestic activity indicators were consistent with near-zero economic growth but, despite this, employment intentions remained very strong and, at face value, suggestive of further falls in the unemployment rate.

It is against this backdrop of stuttering growth but heightened inflation that the RBNZ meets today.  The market is pricing around an 80% chance of a 50bps OCR hike while the economics community is generally on the side of a 25bps move.  Either way, it’s likely to be a line-ball call and valid arguments can be made for both options.  Yesterday saw some stability in shorter-term swap rates, as the market prepositioned ahead of the MPR.  The 2-year swap rate was unchanged on the day, at 3.63%, while the yield curve steepened aggressively, the 10-year rate rising 6bps in response to higher global rates.  NZ rates should be marked sharply lower this morning, although trading activity is likely to be thin before the RBNZ meeting.

Tonight, the Bank of Canada is widely expected to increase its cash rate by 50bps, to 1%, while UK CPI is expected to hit a fresh 30-year high of 6.7% y/y.