US headline inflation fell to 3.1% as expected, thanks to a nearly 9% drop in gasoline prices since last year, although shelter inflation – where everyone sees the biggest potential for easing – remained sticky for another month. Core inflation eased to 4% on an annual basis BUT headline inflation was slightly higher than expected on a monthly basis. And this small uptick has raised suspicions that the Federal Reserve’s (Fed) fight against inflation may be more difficult than expected.
The latter triggered a mini sell-off in the 2-year note immediately following the data, but the sell-off didn’t last long. The US 2-year yield is roughly where it was yesterday morning. Crude oil fell to $68 a barrel even though US oil inventories fell by 2.3 million barrels according to the API.
With the latest inflation report behind us with minimal fanfare, Fed officials will easily keep rates steady this month. The economic projections and the dot plot will play a crucial role in providing insight into the views of Federal Reserve officials regarding expectations for rate cuts.
Fed funds futures activity suggests that the Fed should begin to gently taper rates by May; this possibility is given a probability of around 75%, down from slightly less than 80% before yesterday’s CPI print, while the probability of a March hike has fallen from nearly 50% to around 44% following this mini-surge in monthly headline inflation. In summary, rate cut bets are being placed for a rate cut in March or May 2024. May the best one win.
Today we are likely to see a satisfied, calm but cautious Powell who will say that the Fed has done a great job fighting inflation but that rates will remain restrictive for as long as necessary. One dovish tweak could be the removal of “additional policy firming” from the post-meeting communication.
In the best-case scenario, the doves will make a mountain out of the smallest dovish detail that could justify a further decline in yields. The US Dollar is likely to remain under pressure below the 104.30 level, the major 38.2% Fibonacci resistance that should keep the US Dollar Index in the bearish consolidation zone. We could see the U.S. 10 year Treasury retreat and even – shortly – test the 4% level to the downside, and the 2 year Treasury yield – which captures Fed expectations – to remain between the 4.50/4.70 zone. Anything lower will be unreasonably stretched.
In a more hawkish scenario, Powell will tamp down market optimism and correct rate cut bets. If so, we should see a correction and consolidation in bond and equity valuations in the final weeks of the year.
