Financial markets are stabilising this morning as investors process the implications of yesterday’s soft US inflation print and more hawkish-than-expected Fed decision. The dollar is moving sideways along with the pound and euro, Treasury yields are slipping, and North American equity futures are setting up for a mixed trading day.
The May inflation report was unquestionably positive, consistent with rate cuts beginning in the autumn months. Headline and core consumer price indices increased by less than expected, with declining energy prices putting downward pressure on the all-items measure while a sharp decline in car insurance premiums offset still-stubborn shelter costs. The core goods category fell in year-over-year terms by the most in over two decades as the pandemic’s effect on demand growth and supply chains faded.
The Fed decision itself was a bit of a snoozer, with a mostly-unchanged statement and a non-committal Jerome Powell leaving markets effectively unmoved. Officials acknowledged “modest” further progress toward their inflation target, replacing the “lack” of progress highlighted in the previous statement, and Powell avoided jumping to conclusions after the morning’s data, saying it was “a step in the right direction… but you don’t want to be too motivated by any single data point.”
If any drama was to be found, it was in the “dot plot” summary of economic projections. The median participant now anticipates a single 25-basis point rate cut this year – down from three previously – with eight participants expecting to cut twice, seven forecasting one move, and four seeing none. Chair Powell noted that committee members were permitted to change their estimates after the May inflation report, but appeared (his comments left room for interpretation) to suggest that none availed themselves of this opportunity. This, compounded by an upward revision in the median estimate for the long-run neutral rate, helped the overall decision lean in a slightly more hawkish direction.
Of course, the dot plot should be taken, but not inhaled. A quick glance at the historical record shows that Fed officials are rarely, if ever, correct in their assumptions about the future path of policy rates. The summary of economic projections is useful in capturing the current mood on the Federal Open Market Committee, but isn’t a viable way to assess where interest rates will be in six months, let alone three years.
Today’s producer price index release should help clarify expectations ahead of the core personal consumption expenditures update on the 28th. Taken in combination with yesterday’s consumer price index report, the data should put the Fed’s preferred inflation indicator on course toward printing between 0.10 and 0.15 percent on a month-over-month basis – versus 0.25 percent prior – with declines in some goods categories doing a lot of the heavy lifting in helping to offset continued strength in portfolio-management fees. Deflation in Chinese manufactured product prices has slowed, but the country’s producer price index fell 1.4 percent in May from a year earlier, suggesting that the US import cost impulse remains deeply negative.
We think an initial rate cut at the September meeting remains the most likely outcome. If we’re correct in seeing signs of slowing momentum, continued cooling should be evident in the three inflation prints and slew of consumer spending and employment reports due between now and then. Officials should gain the confidence needed to begin easing policy – and the motivation to do so, given that the November meeting might coincide too tightly with the presidential election.
Mexico’s peso is climbing after the government pre-paid a dollar bond, the central bank threatened to step in, and politicians attempted to jawbone the currency higher. In an interview yesterday, Banco de Mexico Governor Victoria Rodriguez said her institution stood ready to intervene if volatility in the peso becomes too disorderly. Mexico wiped out most of its dollar-denominated obligations for the next year by calling an $894-million note early. And both president-elect Claudia Sheinbaum and her predecessor Andrés Manuel López Obrador made reassuring noises in separate press conferences, pointing to continued strength in the economy. The exchange rate remains roughly 10 percent weaker relative to May’s close as political risks weigh on investor demand for the currency.
The Japanese yen is retracing lower as carry trading activity – which involves selling the currency and buying higher-yielding units – resumes in the aftermath of yesterday’s US inflation release. With the Bank of Japan meeting now underway, we think policymakers could decide to lower monthly asset purchase volumes from the current 6 trillion yen, while also rhetorically preparing the ground for a hike in July. Moves will be gradual, however: inflation may be running above target, but very little is driven by domestic demand, growth is still moribund, and the country’s extreme fiscal indebtedness will force officials to move carefully when reducing the Bank’s footprint in bond markets. Rate differentials should remain wide for now, favouring continued yen weakness.
The Canadian dollar is trading on a firmer footing, benefiting from a broad-based improvement in global risk appetite. The domestic calendar is light through to next Friday’s retail sales report, but the currency is exhibiting its recently-typical inverse correlation with Treasury yields, suggesting that markets remain worried about rate exposures within the country’s household sector. Canadian households broadly failed to deleverage during the global financial crisis and turned real estate speculation into a national pastime over the following decade, lifting debt as a share of gross domestic product to the highest among Group of Seven countries – implying that the economy’s sensitivity to elevated borrowing costs is also the most acute.
