Yesterday brought the latest read on inflation with the Consumer Price Index (CPI), and the news was very encouraging across the board. Headline CPI fell month over month for the first time since May 2020, while core CPI rose just 0.1%, the smallest increase since January 2021. Over the past three months, Core CPI has been rising at just a 2.1% annualized pace – which is basically at the Fed’s target. Importantly, digging into the numbers shows that shelter inflation is finally showing signs of cracking, while core services ex-housing declined – two areas that the Fed has been keeping a particularly close eye on. The market immediately reacted with bond yields plunging & the dollar selling off, which sparked a big rotation out of mega-cap Tech stocks into other areas of the market that have been lagging (i.e., virtually everything else): small and mid-caps, regional banks, interest rate sensitive sectors like REITs & Utilities, precious metals, etc.
With inflation trending lower again and more signs that the economy is cooling along the lines of a soft landing, it seems that the stage is being set for a rate cut in September. This doesn’t mean that the Fed is going to be aggressively easing but rather recalibrating policy to be less restrictive. Now that the labor market is noticeably softening, future risks are more evenly balanced between inflation and employment. Therefore, the Fed will need to be attuned to both sides of their mandate moving forward instead of primarily focusing on battling inflation. With that shift in mindset, the risk of simply remaining on hold while inflation continues to decelerate is that it may unintentionally cause a “stealth tightening” as the “real” Fed Funds Rate (the FFR adjusted for inflation) rises – which is something the Fed wants to avoid. It’s worth noting that a gradual easing cycle is a good thing for a couple of reasons: first, the only reason to ease aggressively is if something is really “wrong” with the economy, which isn’t the case right now, and second, previous examples of slower easing cycle show that stocks tend to perform better compared to faster/aggressive easing cycles.
The market reacted quickly to the realization that the September Fed meeting is likely to be “in play.” Futures pricing shows that odds of a rate cut by September started out the year as a near certainty, sank to less than a 50% chance by late spring in response to hotter inflation readings in the first part of the year, but began to rise again recently as inflation data started cooperating again and just spiked to 95%.
Source: CWA, Bloomberg, Bureau of Labor Statistics, as of 7/11/24
Source: Axios, CME FedWatch, as of 7/11/24
Carl Noble, CFA
Senior Vice President of Investments
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