US CPI surprises to the downside, core inflation falls to 20-mth low below 5%. RBNZ delivers as expected. Risk assets rip higher on the narrative the Fed may be done after its July hike

By Stuart Talman, XE currency strategist

Risk assets have taken flight, propelled higher by a softer-than-expected US CPI report for June, bolstering the case for the Fed to keep the Fed funds target rate on hold following a widely expected quarter point hike on 26 July.

The Nasdaq and Dow have reached their highest levels since April 2022, extending 2023's fierce rally on the view that a Fed that is very close to the tightening finish line increases the likelihood the US economy can avoid recession. To date, US business and household activity has remained resilient in the face of 500bps of monetary tightening given labour market conditions have not materially deteriorated.

The New Zealand dollar is one of the stronger performing G10 currencies, ripping higher on the downside inflation miss, breaking out of a congestion zone that had capped NZDUSD upside below 0.6225 over the past 6 trading days.

Gaining over one-and-three-quarter percent, it’s the second largest intraday gain for the Kiwi, this year, logging overnight highs a few pips shy of 0.6310. Reaching two month highs, the next test for NZDUSD, should price action find a foothold above 63 US cents in the days ahead, is major resistance around 0.6380. Dating back to early February, the pair has failed on four prominent attempts to break through.

So, why such a pronounced move, overnight?

Headline inflation in the US declined from an annualised rate of 4%, the month prior, to 3% (3.1%, expected), its lowest level since April 2021 and well below the June 2022 peak of 9.1%. Core inflation, which strips out volatile food and energy prices, declined from 5.3% to 4.8% (vs 5%, expected) marking the slowest pace of inflation since October 2021. Core inflation peaked at 6.6% in September.

Encouragingly, the month-on-month readings for both headline and core CPI for June were at 0.2%. Consistent monthly prints of just below 0.2% are required to return inflation back the Fed's 2% target.

Whilst the Fed, inflation doves and US equities will be cheering the result, it likely does not alter the Fed's near-term path, still on track to lift the target rate to 5.25% - 5.50% in 14 days' time. However, it does question the need for a September or November hike, which likely won't be delivered should consumer prices continue to recede over the next couple of months. This is expected to occur given rents, the largest CPI component are expected to materially decline.

Against this backdrop, US stocks can extend higher provided the macroeconomic data flow and company earnings do not significantly deteriorate through 2H. On the earnings front, 2Q reporting season kicks off Friday with the large banks releasing their June quarter results and projections.

Having rallied throughout June and into July, US bond yields plunged overnight, dragging the US dollar lower. The two-year yield which is more sensitive to Fed policy relative to the benchmark ten-year, peaked through 5.10% last week, its highest level in 16 years. Four days of firmer bond prices has driven the yield back through 4.80% and may be the start of a new softer dollar regime.

Although, it is still far too premature to declare victory, the inflation battle is yet to be decisively won.

The other two major event from Wednesday, the RBNZ's and Bank of Canada’s interest rate decisions, delivered as expected - no change from the former, whilst the BoC raised the policy rate 25bps to 5.00%. The key takeaways from the RBNZ meeting:

• RBNZ holds, maintains OCR at 5.50%
• Monetary conditions restricting activity
• Inflation risks currently balanced

Whilst the RBNZ acknowledged that inflation remains too high, the accompanying statement conveyed confidence that inflation is tracking as expected, commenting.

The level of interest rates are constraining spending and inflation pressure as anticipated and required. The Committee agreed that the OCR will need to remain at a restrictive level for the foreseeable future, to ensure that consumer price inflation returns to the 1 to 3% annual target range, while supporting maximum sustainable employment.

Current market pricing projects the RBNZ will hold the OCR at current levels for close to 12 months before monetary easing commences during 2H 2024.

Of course, the incoming data flow will dictate the OCR path…..the RBNZ may not quite be done. With CPI still above 6% (as reported via 1Q CPI), additional tightening may be required should inflation remain persistently high. A tight labour market, stabilising house prices and higher net migration, are factors the inflation hawks cite to remind that upside price pressures may persist.

Looking to the day ahead, the economic calendar contains mostly tier 2 data releases with US PPI the sole tier 1 release. Core producer prices are expected to grow at an annualised 2.6%, the slowest pace since January 2021.

Will the risk rally continue through Thursday, or will a take profit catalyst appear?

We'll be monitoring how the Kiwi behaves around 63 US cents.

Stuart Talman is Director of Sales at XE. You can contact him here.