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Hot inflation and spending numbers put a summer rate hike firmly on the Fed’s table

The Federal Reserve’s preferred inflation measure accelerated last month, helping lift the likelihood of another rate hike at one of the central bank’s next two meetings, while helping put a floor under Treasury yields and the dollar. According to the Bureau of Economic Analysis, the core consumer expenditures price index rose a faster-than-anticipated 0.4 percent in April from the month prior, up 4.4 percent on a year-over-year basis, beating market expectations for a 0.3-percent gain. Consumer spending climbed 0.5-percent and personal income inched 0.4 percent higher month-over-month, with pandemic-era savings and higher asset values continuing to fuel extraordinarily-strong levels of consumption and employment across the US economy.

Separately, durable goods orders jumped 1.1 percent in April, defying expectations for a -0.8-percent decline,with last month’s print revised to 3.3 percent, up from the previously-reported 2.8 percent. Excluding transportation, orders were down -0.2 percent, but the non-defence, non-aircraft capital goods measure – sometimes used as a proxy for corporate capital investment demand – rose 1.4 percent, smashing forecasts for a -0.1 percent drop.

More broadly, risk appetite is showing a marked improvement as signs of progress in the US debt ceiling negotiations combine with huge gains in North American stock markets to help lift investor spirits. Discontinuities in front-end Treasury yields are showing signs of easing, equity futures are pointing to a solid open, and commodity prices are advancing after suffering losses earlier in the week. The dollar is giving back some of yesterday’s gains – which, beyond raising disquieting questions about whether froth in the artificial intelligence space might be influencing the value of entire countries – looked somewhat unsustainable given the technical nature of Germany’s weaker-than-expected gross domestic product print.

The Canadian dollar is back on the defensive as worsening yield differentials offset a modest improvement in oil prices. The spread between front-end bond yields has widened out this week, with the US two-year paying almost 27 basis points more than its Canadian equivalent, while the ten-year gap has narrowed to 54 points. Technical resistance appears to have firmed near the 1.3665 level, particularly after last night’s push higher, with support emerging around the 1.3580 mark. We think the 1.3800 area remains within the realm of possibility if the debt ceiling debacle worsens, but a deal could deliver a sequential lifting in Canadian rate expectations and push the pair back toward the 1.3300 level last reached in early April.

Later this morning, markets think the University of Michigan’s consumer sentiment index will hold at 57.7 in late May, unchanged from levels reported earlier in the month. 

Next week might kick off on a subdued note, with Monday’s Memorial Day holiday freezing trading in North American fixed income and equity markets – but thin liquidity conditions could also exacerbate any reaction to a debt ceiling deal on foreign exchange bourses. Wednesday’s US April job opening and labour turnover survey should show a continued decline in the number of vacancies, but overall demand for workers is expected to remain extraordinarily high. Year-over-year headline inflation in the euro area, set for release on Thursday, is seen tumbling to 6.2 percent from 7 percent in the prior month, and government transport subsidies should help drive a decline in core rates as well. The latest US non-farm payrolls report, due on Friday, and coming before Fed officials enter their pre-decision blackout period, could materially impact the odds on a rate hike in June. Markets currently expect job creation to decelerate to 175,000 in May from the surprisingly-strong 253,000-position print in the previous month, but forecast dispersion remains wide, and another upside shock could push some policymakers toward supporting continued tightening.

The House of Representatives is now off for the Memorial Day weekend, leaving negotiators racing to agree a deal before activity resumes on Tuesday. Media reports suggest that the two sides are getting closer to approving a two-year increase in the debt ceiling, with funding for the military increasing while non-defence discretionary spending is capped near current levels – a framework that would avoid making any politically-unpalatable cuts to medical and retirement programmes, and do little to change a decades-long deterioration in the US fiscal position.

We should note that a deal announcement could touch off a dollar-negative relief rally, but is likely to leave major questions unanswered. Until push comes to shove on the floor of the House and Senate, we won’t know whether the country’s elected representatives are willing to support its terms. With the odds on late-2023 rate cuts also plummeting in recent weeks, we can’t quantify the degree to which debt ceiling worries temporarily lifted the greenback. And we don’t know how a renewed post-deal ramp in Treasury issuance might impact liquidity conditions – particularly when set against a Federal Reserve that is simultaneously attempting to steer the economy toward a soft landing. 

Note: Our daily market briefings will resume on Tuesday, but we will be watching for news of a breakthrough in Washington, and will keep you updated on any developments with market-moving implications. Have a great long weekend!

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