US inflation complicates US interest rate outlook

An interest rate cut from the Federal Reserve next week of 25bps is now fully baked into markets, and hopes of a 50bp cut have been scaled back, after stronger than expected core price growth in the US. Today’s inflation data also complicates the outlook for rate cuts further in the future. 

The headline rate of US inflation moderated to 2.5% in August from 2.9% in July, which was expected by the market. This is close enough to the 2% fed inflation target to justify the start of a rate cutting cycle. However, does it justify the 10 rate cuts that are currently priced in by the Fed Funds market over the next 9 months? 

Core prices stayed steady at 3.2% YoY in August, however, on a monthly basis, the pace of core inflation picked up to 0.3% from 0.2%. Shelter costs and owners equivalent rent picked up to 0.49% MOM in August, higher than the 0.3% rate in July. Stubborn shelter costs weighed on core prices, and is a keen reminder that housing costs continue to be a source of inflationary pressure. 

Super core service inflation, which was once the most highly watched part of the inflation report but has recently dropped back in terms of significance for the Fed, rose by 0.33% in August, up from a 0.2% gain in July. This index strips out shelter costs, suggesting that wage pressures might be showing initial signs of building as we head into the Autumn months. 

We continue to believe that the US labour market is not weak, even as NFPs remain volatile. Thus, it is worth watching the super core service price index each month, in case it starts to trend upwards suggesting that wage growth could rise and the labour market may be gathering strength. 

US Stock index futures edged lower, and bond yields crept higher on the back of this inflation report. The 2 year yield is now 6 bps higher on Wednesday. If there is a recalibration of rate cut expectations, we think that the 2 year yield could return back towards 4%, as traders price out some of the excessive rate cuts priced in for the rest of this year. 

If that happens then it may spur a dollar recovery. The dollar has made a tentative recovery on Wednesday, and USD/JPY has picked up from the 141 lows from this morning. 142.50 is the next resistance level of note for this pair. 

We think that a reduction in rate cut expectations is good news for US stocks, especially for value stocks and the non-tech sectors. This would suggest that the US economy is stronger than some suggest and it would be a sign that recession risks have been reduced. Thus, any decline in stocks on the back of the inflation report may be short lived.