Another downside US CPI miss. Market pares Fed rate hike expectations. UST yields lower across the curve

Another US CPI downside miss has driven risk appetite higher alongside much lower US rates, supporting equity markets and leading to a large broad-based fall in the USD. NZD, AUD and JPY lead the gains, with the NZD temporarily breaking above 0.65.

Santa Claus has come early for the market with the gift of a second consecutive downside miss to the US CPI, coming in at 0.1% m/m and 7.1% y/y with the ex-food and energy (core) measure at 0.2% m/m and 6.0% y/y. The monthly lift in the core measure was the smallest increase since August 2021. The consensus was at 0.3%, with the risk of a higher 0.4% increase, so the data were another pleasant inflation surprise, providing further confirmation that inflation is heading down. Importantly, there were some signs of easing services inflation such as for rents, with leading indicators suggesting further moderation ahead.

The data comes ahead of the FOMC’s latest forecasts and policy announcement in just over 24 hours. The softer CPI print has cemented in expectations of a dialled-down 50bps hike tomorrow, taking the Fed Funds target range to 4.25-4.50%, while the market has also pared back further tightening expectations, with a dialled-down 25bps hike in early February now seen as more likely than another 50bps (an incremental 33bps priced).

The Treasuries yield curve has moved lower and steeper, with the 2-year rate down 16bps to 4.21% and the 10-year rate down 12bps to 3.49%, the latter falling to as low as 3.41% overnight. The USD has been whacked, with the DXY index down about 1% for the day and to its lowest level since June. The S&P500 was up as much as 2.8% early in the session, with the gain pared down to 0.4% as we go to print, but following the 1.4% gain yesterday after a late rally.

The Fed is already split between doves and hawks – as evident by the wide dispersion of the previous dotplot of Fed Funds projections – and the data are likely to reinforce that split. While the inflation data will be welcomed, the data tell us nothing about where inflation might settle.  The hawks will be pointing to the still-strong labour market and uncomfortably high wage inflation data which will support the economy and make the task of bringing inflation to target harder, while the doves will be pointing to the leading indicators suggesting that much lower inflation lies ahead and the full force of tighter policy has yet to work its way through.

Chair Powell – who wants to avoid the legacy of 1970s chair Arthur Burns who let inflation get out of hand – has the opportunity tomorrow to be the Christmas grinch and argue policy needs to tighten further and remain restrictive for some time to be sure of bringing inflation back down to target. There could well be some unease about the extent to which financial conditions have eased considerably over the past couple of months, working against the Fed’s motive to tighten monetary policy. The softer CPI print is unlikely to change resident hawk Bullard’s view that the policy rate needs to get to 5-5.25% “at a minimum”, compared to market pricing which currently sits at a peak of 4.85% and some 50bps of easing built into the curve through the second half of next year.

Strong risk appetite and lower US rates have seen a broad-based fall in the USD with the NZD, AUD, and JPY outperforming. The NZD surged to as high as 0.6513 before settling down to 0.6465 for an overnight gain of 1.4%. The AUD found some resistance just over 0.6890. With much lower US Treasury yields, USD/JPY fell below 135 and it currently sits just above that level. Gains for EUR and GBP have been less than 1% overnight.  CAD has underperformed with an even smaller gain – given its strong link to the US economy – despite a decent 3-4% rally in oil prices which sees Brent crude back above USD81 per barrel, having now unwound about half of last week’s hefty 11% loss.

In other economic news, UK wages inflation strengthened further to 6.1% y/y for the widely followed weekly earnings excluding bonuses figure, reflecting the tight labour market with the unemployment rate at 3.7% and high cost of living backdrop. Rail workers have begun a strike and nurses and other professions are set to follow.  All this ahead of the BoE’s meeting later this week, with most MPC members uncomfortable with the inflation backdrop even with the economy likely already in recession.

Domestically, REINZ’s house price index fell a chunky 1.4% m/m or an even greater fall seasonally adjusted, given that prices usually show a seasonal lift at this time of year. The index was down 13.7% y/y, with Auckland and Wellington leading the falls at 18.4% and 19.5% respectively, with a matter of time before other regions follow. Activity remained depressed with sales down over 36% y/y. Plenty more pain is likely to be seen in the housing market as higher mortgage rates continue to gradually filter through. Against the backdrop of falling asset prices, the higher cost of living continues to bite, with food prices still strong, accounting for the usual favourable seasonal influences at present, driving a further lift in the annual increase to 10.7% y/y.

The domestic data had no impact on the rates market, with rates higher across the curves largely a function of global forces with some NZ underperformance and curve peculiarities thrown in.  The 2 and 10 year swap rates were up 4bps and 7bps respectively, a steeper curve, while the NZGBs curve flattened, with 5-7 year rates up 6-7bps, a 5bps increase in the 10-year rate to 4.15% and still-strong demand for the 2051 bond sending it down 1bp to 4.19%. The Australian 10-year bond future has traded a 13bps range since the NZ close, but with the implied yield now only slightly lower.

In the day ahead, NZ’s annual current account deficit is expected to crack a record 8% of GDP, a sign of an overheated domestic economy through much of the past year. The government’s economic and fiscal update should show a deterioration in the outlook, including projections of a larger debt issuance programme. RBNZ Governor Orr appears before Parliament’s Finance and Expenditure Committee at 1pm for the 2022 Annual Review. UK CPI inflation data released tonight will remain uncomfortably high, ahead of the BoE’s meeting later this week.