It starts tonight! The key battle of the Fed's "first cut" is about to begin

Golden Ten New Media

2024-05-14 13:57Published in Guangdong

While many economists are optimistic that inflation will continue to slow, no one underestimates the possibility of a "surprise".

Three consecutive months of hot inflation data have undermined Wall Street's confidence that a series of rate cuts is about to begin, and they are now hoping that the fourth CPI data of the year will show "good momentum".

In the days leading up to Wednesday's CPI report, optimism about a soft landing for the U.S. economy swept through the market again. Fed Chair Jerome Powell kept hopes of a rate cut alive after the Fed's latest policy meeting. Subsequent data showed that pressure on employment and wage growth eased, helping to push U.S. stocks back to record highs.

Persistent inflation has been a major issue plaguing investors in recent months. At the start of 2024, traders were betting that the Fed would cut interest rates more than six times this year, but when CPI continued to be higher than expected, they had to quickly taper their bets and push Treasury yields to their highest level since November last year.

Many investors said that the April non-farm payrolls report alleviated some of their concerns, as a cooling labor market should eventually lead to slower price increases. Now, they just need actual inflation data to back up this view.

Gennadiy Goldberg, head of U.S. rates strategy at TD Securities, said, "The CPI report is likely to go a long way in furthering the narrative that the Fed will cut rates this year." ”

Is U.S. bonds better than U.S. stocks?

U.S. equities and U.S. Treasuries are correlated. The yield on U.S. Treasuries is heavily influenced by investors' expectations of short-term interest rates set by the Federal Reserve, while stock prices are influenced to some extent by investors' exposure to the risk-free return they will receive from holding U.S. Treasuries to maturity.

The Dow Jones Industrial Average has risen 4.5% this month, less than 1% from the record set at the end of March. Higher U.S. Treasury prices pushed the 10-year Treasury yield to around 4.5% from 4.7% at the end of April.

Many investors believe that if inflation slows, Treasuries will rise more than U.S. stocks. While the latter is close to all-time highs, the yield on 10-year Treasuries is still well above the level of less than 4% at the beginning of the year.

Over the past few years, Treasuries have returned disappointing as interest rates have climbed higher than investors expected and stayed at these levels for longer than expected. Still, whenever there are signs of slowing inflation, investors are quick to buy Treasuries, rushing to lock in yields of 4%-5% before the Fed starts cutting rates.

Ed Perks, chief investment officer at Franklin Income Investors, said he expects yields on short-term Treasuries to fall by 0.2-0.25 percentage points and long-term Treasury yields to fall by 0.1-0.2 percentage points if data show a slowdown in inflation.

At the same time, he said it was "more challenging to see a big rise in equities" given current stock valuations. He added that for the same reason, if inflation is higher than expected again, the stock market could have more room to fall.

"Inflation is going to be a little tricky"

U.S. inflation has fallen sharply from its peak in 2022. The problem is that the Fed's preferred PCE price index has not yet returned to its 2% target. The year-on-year growth rate of the core PCE price index fell to 2.9% at the end of last year from 4.9% at the beginning of the year. But it has since stagnated, at 2.8% in March.

Wednesday's CPI report will provide investors with a better than usual look at what exactly will happen to the PCE price index later this month. This is because the PCE price index includes some CPI and PPI data sub-items.

Typically, the CPI data will be released before the PPI report, leaving investors with some uncertainty about the Fed's preferred indicators. But this month's PPI data will be released on Tuesday, allowing investors to quickly calculate what the pace of growth of the PCE price index will be in April on Wednesday morning.

Many economists remain optimistic that inflation will return to the downside. They noted that goods inflation has slowed to the level the Fed wants. Official housing inflation measures have remained high, but economists still expect them to moderate and be more consistent with the private sector's measure of new rent increases.

Inflation for other types of services tends to rise and fall slowly. But recent reports show that the cooling of the labor market is a positive sign, as labor costs are often the main driver of price changes for such products.

In addition, economists note that inflation for certain types of services tends to lag behind inflation for related goods. So, given what is already happening in new and used car prices, many expect the rise in car insurance or repair costs to slow down in the coming months.

However, no one is currently underestimating the likelihood of an inflation surprise in any given month. George Mateyo, chief investment officer at Key Private Bank, said it would still be wise to hedge against the risk of overheated data by holding unconventional assets such as real estate, inflation-protected bonds or international equities, given that poor economic reports could hurt the U.S. stock and bond markets. He said:

"We think inflation is going to be a bit tricky."

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