Another US CPI shocker - to the upside, following last month's downside surprise. Market ramps up Fed tightening expectations. Risk appetite sours

A much stronger than expected US CPI print shocked a market that was positioned for another good result. The markets see the Fed reacting with tighter policy, with the debate shifting to a 75bps or 100bps hike next week. Rates are higher across the curve, led by the short end, causing more curve inversion. The USD showed broad-based strength and the NZD has broken below 0.60 again to fresh lows. US equities are down in the order of 3-4%.

The US CPI lived up to its top billing for the week, with a much stronger than expected figure driving a significant market reaction. Headline inflation in August was dragged down by a hefty fall in gasoline prices but rose 0.1% m/m against expectations for a 0.1% fall.  The ex-food and energy core measure rose 0.6% m/m, a chunky 0.3 percentage points above the market, lifting the annual increase to 6.3% y/y. Alternative core measures like the Cleveland Fed’s trimmed mean and Atlanta Fed’s sticky CPI showed underlying inflation picking up over the month, with both recording annualised figures of 7.7%.

While the market was hoping to see a second consecutive month of fading inflationary pressure, what we got was signs that inflation was broadening, capturing more of the services sector on the back of an over-stimulated economy.  Services inflation is often stickier than for goods prices, meaning that any return to inflation normality is a long way off yet.

With the market caught off-guard, there was a significant reaction across equities, bonds and currencies. The S&P500 is currently down 3½%, wiping out the gains of the past few trading sessions. US rates are higher across the board. A 75bps hike next week was already largely baked in but the market now entertains the chance of a mega 100bps hike, with 83bps priced in, and a higher peak Fed Funds rate of now close to 4.3% for early next year. The Fed clearly has much more work to do to rein in inflation.

The Treasuries curve shows a sharp flattening, with the 2-year rate up over 20bps to a fresh 15-year high of 3.79%, now 3.76%, and the 10-year rate up 7bps to 3.43%, resulting in the 2s10s curve inverting by 12bps to minus 33bps, a stronger signal of economic recession risk next year, although still shy of the minus 49bps the gap reached just over a month ago. Higher US rates have spilled over into other markets, with key European 10-year rates up in the order of 6-9bps.

Market hope for a soft CPI print and higher risk appetite, on the back of the UK and EU looking to address their local energy crisis and Ukraine’s military “win” over the weekend, had driven the USD weaker over recent trading sessions, but a strong CPI print has seen a sharp reversal. This reflects a combination of higher US rates and safe-haven flows from much weaker risk appetite. The DXY USD index is up 1.3%.

The NZD and AUD show the largest falls, the NZD down 2.2% from this time yesterday to just below 0.60, and the AUD down 2% to below 0.6750. NZD/AUD has slipped below 0.89 again. Falls over the past 24 hours for the other key majors are in the order of 1-1½%, with EUR back below parity, GBP closing in on 1.15, and USD/JPY up to 144.50.

The stronger USD has had the usual impact of reducing commodity prices but price falls in oil were pared after a report that the US government may begin refilling its emergency oil reserves when prices drop to around USD80 per barrel, which could help put a floor under crude. WTI currently trades at USD87.

In other news, more details on the EU’s energy plan continue to be leaked out. Bloomberg reports that the EU is looking to cap the power-generation revenues of renewable and nuclear companies at EUR180/Mwh; introduce a temporary level on companies in oil, gas and refinery industries of at least 33% of extra profits relative to a baseline of FY22, and a target to cut overall consumption by 10% and a mandatory goal lowering demand during selected peak hours by 5%. Details will be debated over coming weeks and will need to be agreed upon by EU states.

Presidents Xi and Putin are set to meet on Thursday on the sidelines of a summit in Uzbekistan. The world will be interested in whether Xi still sees a “no limits” friendship with Russia after the Ukraine invasion.

UK’s unemployment rate surprisingly fell to 3.4%, its lowest level since 1974. But the fall was driven by lower labour force participation due to sick workers, with the 40k gain in jobs weaker than expected. Wages ex bonuses grew 5.2% y/y. Tight labour markets can only encourage the BoE to continue hiking rates, despite the economy being on the verge of recession.

NZ’s food price index rose 8.3% y/y in August, the strongest inflation in 13 years. That was slightly higher than expected, but not enough to change our Q3 CPI pick of 1.5% q/q and 6.5% y/y. REINZ housing market data were about as bad as expected, with ongoing low levels of sales activity and another drop in house prices taking their fall since the November peak to 12%, with the likelihood of much more to come yet.

The domestic rates market showed lower rates across the NZGB and swaps curve in the order of 2-5bps, but global forces will drive rates higher today. Since the NZ close the Australian 10-year bond future is up 12bps in yield, which will set the tone in early NZ trading today.

In the day ahead, the market sees NZ’s current account exploding higher to 7.5% of GDP, something the run of poor trade data has been signalling. UK CPI inflation is the key global release tonight, with headline inflation expected to be relatively steady around 10%. After the overnight reaction to the US CPI data, the PPI release should be a more sedate affair.