Strong US CPI inflation data destroys the inflation-has-peaked narrative. Stagflation in focus as US consumer sentiment falls to a record low as well and long-term inflation expectations rise

On Friday, another US CPI shocker sent markets in a tailspin, driving US equities down about 3%, a sharp flattening in the US Treasuries curve, led by a 25bps increase in the 2-year rate, and the USD higher. Euro area peripheral bond spreads continued to widen in the aftermath of the ECB meeting, a trend that needs to be monitored carefully. The NZD was trying to recover Friday evening, but USD strength pulled it down and it closed the week about 0.6360, but with gains on most of the key crosses. NZ rates continued to rise, with the 10-year government bond closing at a fresh 7-year high of 3.93%.

The US CPI rose 1.0% m/m, a chunky 0.3 percentage points ahead of expectations, taking the annual increase to a fresh forty-year high of 8.6%. Core inflation was also stronger at 0.6% m/m, a run-rate that remains far too high for comfort.  Inflationary pressure was broadly based, and no matter what way you diced the numbers, ex this or that, weighted median, trimmed mean or sticky CPI measures, they all showed rapid price gains, dealing a blow to those who thought inflationary pressure was on the way down.

Ninety minutes later the University of Michigan survey showed a 6-point fall in consumer sentiment, taking it down to a record low in the survey’s 44-year history, both current and expectations components showing decent falls. This illustrated the damage higher inflation was doing to confidence, with a strong labour market providing no support, with earnings power being eroded by inflation. The survey’s measure of 5-10 inflation expectations rose from 3.0% to a 14-year high of 3.3%, hinting that longer term inflation expectations might be becoming unhinged.

Suffice to say, there was nothing to celebrate in these data releases and the market concluded that the Fed had plenty more work to do to bring inflation under control. The market priced in a more front-loaded and extended hiking cycle, with 50bps now priced for the next three meetings, with some chance of the Fed hiking by 75bps at any one of those meetings, and Fed Funds rate priced to be almost 3.25% by year-end. There was a sharp flattening of the Treasuries curve, with the 2-year rate closing a significant 25bps higher at 3.06%, the first breach of the 3% mark since 2008.  The 10-year rate rose 11bps to 3.16%, trading as high as 3.18%, just shy of the 3.20% peak in early May.

The strong inflation data makes this week’s FOMC more interesting. At the last meeting Chair Powell gave clear guidance that members thought 50bps hikes were on the table for the next couple of meetings and he said that a 75bps hike wasn’t something the FOMC was actively considering. The odds still favour the Fed moving in 50bps increments, but Chair Powell will have the chance to keep the upside pressure on rates by delivering a very hawkish missive.

Equity markets didn’t like the stagflation message from the economic data and the S&P500 fell 2.9%, closing at its low for the day and taking the weekly fall in the index to over 5%. The Euro Stoxx 600 index fell 2.7%, taking its loss for the week to 4%.

Higher US rates spilled over into the European market, itself still finding its feet after the hawkish ECB policy update the previous day. Germany’s 10-year rate rose 9bps to 1.51%, with larger increases for the peripheral markets.  Spain and Italy 10-year rates rose 16bps while Greece’s 10-year rate rose a meaty 28bps – the market being disappointed in the ECB’s lack of detail in a “new tool” to combat market fragmentation within the euro-area. This is a trend that needs to be watched carefully as the last thing the economy needs right now is another European debt crisis. The risk is that the market takes peripheral bond spreads a lot wider, forcing the ECB to eventually act.

For the USD, the market’s pricing of a more aggressive path for US monetary policy and its safe-haven status as risk appetite fell, resulted in broadly based strength, with dollar indices up in the order of 0.8-0.9% on the day. The yen recovered after a rare joint statement by the BoJ, MoF and FSA indicating they were “concerned about recent currency market moves” and would monitor FX developments “with a greater sense of urgency”. USD/JPY fell to as low as 133.40 before its recovery was interrupted by the USD gaining ground, resulting in a net flat performance on the day, closing at 134.40.

The NZD rose to as high as 0.6435 Friday evening, before USD strength took it lower, ending the week about 0.6360, capping off a poor week which saw it down over 2%. Still, against a backdrop of weaker risk appetite, it outperformed on most of the key crosses on the day, particularly with EUR and GBP showing notable falls.  NZD/GBP was up 1% on the day to 0.5160 while NZD/EUR was 0.5% higher at 0.6045. NZD/AUD showed a further small recovery, closing the week around 0.9020.

In other news, Canada’s employment report was strong, with stronger than expected payrolls driving the unemployment rate down to 5.1%, the lowest level in data going back to 1976. This will keep the pressure on the Bank of Canada to continue raising rates in 50bps increments and Canada’s 2-year rate was up 17bps to 3.23%.

Beijing and Shanghai both resumed mass testing to contain another outbreak of COVID19 in the community. To outsiders this looks futile, given the infectiousness of Omicron, but this is all part of President Xi’s plan to prevent deaths to an inadequately vaccinated elderly population and it’s difficult to have anything but a pessimistic view of China’s economic outlook as long as the plan continues.

In domestic news, NZ Q1 activity data for various sectors of the economy allowed us to firm up our GDP estimate for the quarter, with BNZ’s economics team leaving it at flat, with the risk slightly skewed to the downside. While a negative GDP outcome later this week could see the media jump on it like a rabid dog, the quarter was weighed down by Omicron-related restrictions and an easing of those will see a bounce-back in Q2. The makings of that were evident in electronic card spending data, with a rise of 1.4% m/m in May following the strong 7.3% m/m gain in April. Both overstate the rebound in activity, given the very strong inflation backdrop, but the data go a long way in setting the scene for a better Q2 GDP outturn.

The bias for NZ rates remained to the upside.  NZ swap rates closed 4-5bps higher, with the 2-year rate closing above 4% for the first time since 2014. NZGBs continued to show a bias to steepen. The 10-year NZGB closed 5bps higher at a fresh 7-year high of 3.93%. Australia 10-year bond futures are up 12bps since the NZ close on Friday, setting the scene for much higher rates when the NZ market opens today.

The economic calendar is light over the day ahead, with monthly GDP and other activity data released in the UK tonight. In the week ahead, the domestic focus will be on Q1 GDP, where the market consensus sits at 0.5% but with three of the four major banks, including ourselves, picking a flat result.

The global calendar is action-packed, with plenty of scope to move the market. The FOMC’s latest policy update is the highlight early on Thursday morning, where the Fed has guided for another 50bps rate hike but after the strong inflation data a larger 75bps hike remains the greater risk than a smaller 25bps hike. At the end of the week, the Bank of England and Bank of Japan meet, with expectations for a 25bps hike from the former and the BoJ likely to resolutely maintain its super-stimulatory stance, against the grain of other major developed central banks, although the market will be watching for any further commentary on the concerns about the yen.  In global economic data, watch out for US retail sales, Australian employment and China monthly activity indicators.