US data firms up rate cut bets, as ECB sounds optimistic on the growth outlook

US CPI was in line with expectations, the headline rate rose to 2.9% YoY in August, up from 2.7% in July. The monthly rate was a touch stronger than expected and rose at a 0.4% monthly pace. Although this suggests that US inflation is running well above target, it is not seen as an impediment to further rate cuts.

In the aftermath of this report, the dollar has done a 180 degree turn and is lower across the board. S&P 500 futures have whipsawed slightly, but are now higher on the day, and US bond yields are declining. This price action suggests two things: 1, there is a high bar for the Fed not cutting interest rates in the coming months, 2, the labour market continues to trump the inflation print and could do for some time.

Digging a bit deeper into the CPI data, as usual the shelter component of the CPI saw the largest monthly increase and was higher by 0.4%. Food and energy prices also saw large increases. Crucially, for Fed rate cut bets, these components are not linked to tariffs. If tariffs are not putting upward pressure on prices at this stage, then the Fed could look through the rise in commodity prices and still cut rates even if CPI is above the 2% target rate.

Used car prices pick up in nod to tariff impact

There was one area where tariffs impacted on the CPI report: used car and truck prices. This sub index rose by a whopping 0.9% in August, after four straight months of losses. As tariffs boost the price of Asian and European cars, it looks like American consumers are either buying domestically or are happy to trade down and buy secondhand cars that are not  subject to tariffs. In contrast, new vehicle prices fell by 0.1% last month.

On the back of this report, the focus has been on further rate cut bets. There is now an 11% chance of a 50bp rate cut next week from the Fed, which raises the possibility that the Fed is behind the curve and will need to play catch up over the coming months. There was an 8% chance of a 50bp rate cut ahead of this report.

Lack of feed through from tariffs to US inflation is positive for rate cut bets

While a 2.9% CPI rate is not exactly dovish, the lack of feed through from tariffs into the CPI report could ease Fed concerns about the future path of inflation. Added to this, there was more weakness in the US labour market. Initial jobless claims jumped from 236k to 265k last week, which is one of the highest levels over the last 4 years. This supports the view that the Fed should be focused on the deterioration in the labour market rather than inflation risks, and it supports a 50bp rate cut, in our view.

We expect the Federal Funds Futures market to continue to price in the possibility of a  50bp rate cut from the Fed next week. This is likely to keep a cap on dollar gains, and it could keep downward pressure on US yields, and US 10-year  and 2-year Treasury yields have declined at a faster pace than their European counterparts so far this week.  The10-year yield dipped below the key 4% level in the aftermath of the initial jobless claims report.

ECB remains on hold for the long term, as the growth outlook is ‘more balanced’

The ECB meeting was generally uneventful, the governing council kept rates on hold, as expected, and released their latest growth and inflation forecasts. Although CPI was revised up for 2025 and 2026, it was cut to below the ECB’s target rate for 2027 at 1.9%.

The ECB refused to commit to future policy decisions, as was expected, however, Lagrade did say that growth risks were more balanced (i.e., less bad than previously thought), which is fueling some scaling back of rate cut expectations from the ECB for the rest of this year.

Why the Fed is more important to the markets than the ECB

This has helped to boost the euro, and it has pushed up European bond yields, which are rising mildly across the curve. The past week has seen US bond market outperformance vs. Europe, and we expect this to continue until next week’s FOMC meeting.

The news conference is ongoing, but we expect Lagarde to remain tight lipped about the future of policy, and for financial markets to be more driven by the future of Fed rate policy, especially stocks. For now, that may mean a weaker dollar, a stronger euro and stronger stocks.