US CPI for July much lower than expected; headline inflation past the peak. Modest net reaction in rates market, after earlier plunge in yields, but equities and currencies sustain strong reactions

For a change, US CPI inflation surprised to the downside and this triggered a significant market reaction. US short end rates are lower but the 10-year rate is back to flat on the day after an earlier fall. Risk appetite has exploded higher, driving a 2% gain in the S&P500 and an outsized move in currencies, with the USD down more than 1% and the NZD up more than 2% to 0.6420.

The much-anticipated US CPI report was a shocker. Both the headline and ex food and energy CPI undershot the consensus by 0.2 percentage points, coming in at zero and 0.3% m/m. On annual changes, headline inflation fell from 9.1% to 8.5% while the ex-food and energy measure was steady at 5.9%, with the latter showing an annualised increase of 3.8% for the month. Plunging gasoline prices drove the headline result and further reductions will support another low print next month. Declining airfares, car rentals and hotel prices contributed to the weak result, with the usual summer price hikes not coming through because prices had already shot up so much.

Other measures of core inflation like the Cleveland Fed median and trimmed mean and the Atlanta Fed sticky prices indices all showed some moderation, but annualised monthly rates were still high at 6.5%, 5.5% and 5.4% respectively.

On the facts then, inflation pressures moderated in July and by more than expected, but core inflation remains much too high for comfort for a central bank targeting 2%.  Nonetheless, the data follows what seems to be an endless run of positive inflation shocks.

The Fed has made it clear that it wants to see a string of good inflation outcomes before it becomes more relaxed about the inflation outlook. And the recent strong data on employment and particularly wage inflation also can’t be easily forgotten. As we noted yesterday, the data will not answer the question we all want to know – how quickly inflation will fall over the coming year, so the debate about how much more tightening the Fed will need to do and whether a soft or hard landing for the economy can be achieved will rage on.

Chicago Fed President Evans was speaking after the CPI report and while he acknowledged “the first positive report” on inflation he didn’t seem to sway from his prior view that inflation was “unacceptably high”.  He reiterated his view on further rate hikes this year and into next year, which would take the Fed Funds rate to a range of 3.75-4% “to make sure inflation gets back to our 2% objective”.

Minneapolis Fed President Kashkari also spoke after the CPI report and while he noted he was happy to see inflation surprise to the downside, he noted the Fed was “far away” from declaring victory on inflation and the data doesn’t change his projected path on rate hikes, which sees the Fed Funds rate at 4.25-4.5% by the end of 2023. He said that the idea the Fed will cut rates next year when inflation is very likely going to be well in excess of target is “unrealistic”.

The initial rates market reaction to the CPI report was a big move down in yields, but this has since faded significantly. The 2-year Treasury yields plunged by over 20bps to a low of 3.07%, but has since climbed back up to 3.21%, down “only” 6bps on the day. The 10-year rate fell 14bps to a low of 2.67% but is now back up to 2.78%, roughly flat for the day and near the level at the NZ close. The OIS market has pared back the chance of a 75bps hike next month, with the meeting currently priced for a 58bps hike, down from 67bps at yesterday’s close.

Risk appetite has shot up, with the VIX index trading below 20 for the first time in four months. The S&P500 is up about 2% and the Nasdaq index up 2½%.

There has been an outsized reaction in currency markets and, unlike the rates market, there has been no reversal of the initial move.  The USD is broadly weaker, down 1.1% for the day. The NZD has been one of the key beneficiaries of higher risk appetite, seeing a gain of more than 2%, trading up to a high of 0.6434 and currently around 0.6420. One good CPI report doesn’t change our view on the (poor) global macroeconomic outlook and the strong gain in the NZD presents a good selling opportunity.  The AUD peaked above 0.71 and is up 1.7% for the day at 0.7085.

EUR broke above 1.03 and GBP rose as high as 1.2275. JPY has been choppier, given its sensitivity to the US 10-year rate and after almost touching 132, USD/JPY is back to around 133. Given its outperformance, the NZD is higher on all the key crosses.

Yesterday, domestic rates were higher on global forces, with a parallel shift up in both the swaps and NZGB curves, with almost all rates up 6bps.  The 2-year swap rate closed at 3.84% and 10-year swap closed at 3.52%.

In the day ahead REINZ data this morning are expected to show more bad news on the local housing market, with slumping sales activity at lower prices. With the US CPI out of the way, the global economic calendar through the rest of the week is light. US PPI data and initial jobless claims tonight shouldn’t rock the boat.