Issue 111: Inflation and the Fed

This Week’s Highlights

• CPI speaks to Fed’s conservatism
  October inflation, while in line with analysts’ expectations, showed progress seeming to stall, leading investors to price a more gradualist policy on the part of the Fed: something Powell backed up in comments last week, stating he wasn’t “in a hurry to lower rates”.
• Jobless claims lower than forecast
  Last week’s initial jobless claims offered just the sort of evidence the Fed needs to pursue a cautious approach on rate cuts, with the 12-week average marking its lowest level since May. That was also below expectations, reinforcing a trend of negative surprises.
• Unpacking the dollar’s recent rally
  Given the US dollar’s rise of 3% against major currencies tracked by the DXY index since Donald Trump’s reelection on November 5th, we consider not only some sources of the greenback’s strength, but also how it’s fared against a range of individual currencies.​​​​​​

The CIO’s Take:

• Based on recent months’ data, it’s hard to argue inflation hasn’t gotten stickier, which ought to make the Fed second guess a rapid reduction in rates. Powell’s comments last week seem to support our view that the US central bank is on the verge of a pause in rate cuts after a likely 25-bps reduction at the December FOMC.
• We think US labor market strength is a big factor contributing to Fed’s flexibility in taking things slow on monetary policy, as it clearly offers greater margin for error to central bankers, but will provide no comfort to bond investors pained by further evidence the Fed will draw out its timetable and possibly land on a higher terminal rate.
• As global investors with a healthy international exposure in our asset allocation models, we’re keeping a close eye on a dollar rally being driven by expectations for president-elect Trump’s policies, but also the Fed’s game plan. Given different currencies’ reactions, we see scope for active views on FX to add value in a portfolio context.​​​​​​

Inflation and the Fed

Headline CPI rises in October
With just one FOMC meeting to go before the end of the year, the question has become not by how much the Fed will cut, but whether we get another reduction in its policy rate by December. US inflation is obviously a key data point influencing that decision, making last week’s CPI report out of the Bureau of Labor Statistics (BLS) an important one for investors. For the doves, on the face of it, it wasn’t a helpful one. Headline prices rose by 2.6% year-over-year in October, higher than the 2.4% registered in September, and the first increase in seven months.

Digging deeper, a mixed bag
Things didn’t look much better excluding volatile food and energy prices, with core CPI posting a 3.3% increase, matching its September figure—a rate substantially higher than the Fed’s 2% target for inflation. A measure of so-called “supercore” prices, which focuses on services and excludes shelter costs, in addition to food and energy, also ticked up to a year-over-year rate of 4.4% (see below).

On the other hand, that year-over-year rise in supercore inflation belies the fact that its 0.31% monthly increase is actually the slowest we’ve seen in three months, and below the average for the year, which sits at 0.35% MoM. Both headline and core CPI were also in line with consensus expectations. So, although disinflation looks to have weakened in recent months, at least this wasn’t a negative surprise.

Powell says no hurry on cuts
Of course, what really matters is how central bankers at the Fed feel about all of this. Chair Jerome Powell, speaking last Thursday at an event hosted by the Dallas Regional Chamber, gave us some insight. At a high level, he suggested that robust US growth offered policymakers flexibility to exert caution in lowering rates. Meanwhile, a resilient but gradually cooling labor market means that the Fed need not “be in a hurry to lower rates”, according to the Fed chair. The bond market was naturally less enthused by a measured approach to cuts, and Treasuries sold off on Powell’s remarks.

Optimism inflation will fade
Powell’s confidence stems in part from what he’s seeing in the details of recent inflation reports. That includes a broad softening of prices, the fact that wage increases aren’t likely to contribute much to inflation, and the more nuanced point that some things like the rising cost of auto insurance—up by a whopping 14% year-over-year in October—are actually a sort of “catch-up inflation” that he’s confident will dissipate in due course. The Fed also expects housing costs, which accounted for half of last month’s inflation, to ease as time goes on.

Other Fed officials weigh in
That said, Fed officials have shown varying levels of dovishness in terms of how policy could play out in the months ahead. Boston Fed president Susan Collins, interviewed Thursday, said a December cut is “certainly on the table, but it’s not a done deal”. On Friday, the Chicago Fed’s president, Austan Goolsbee, sounded less reserved, telling CNBC that “as long as we keep making progress toward the 2% inflation goal, over the next 12 to 18 months, rates will be a lot lower than where they are now.” According to CME Group data, traders see a roughly 62% chance of a cut in December.

Labor Market Update

Initial jobless claims fall
Data on jobs will also be critical in the Fed’s calculations, putting some emphasis on weekly numbers coming out of the US Labor Department. Last Thursday’s survey, covering data through the week ending November 9th, seems to back Powell up on the resilience of the US labor market. Despite some regional disparities, the overall count decreased by 4K claims from the week prior to a total of 217K claims. That put the four-week moving average, which smooths out weekly fluctuations, down by over 6K to 221K claims: the lowest level tally back in May.

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A string of downside surprises
We’ve commented in recent months on the impact that hurricanes and strikes have had on labor market data, and that’s definitely shown up in jobless applications. Layoffs announced by the likes of Boeing and Stellantis are likely to contribute further to the volatility in months ahead. Nevertheless, zooming out and looking at the trend in surprises on things like jobless claims (see below), it’s clear the overall trend has been lower-than-expected claims, which is positive for labor market strength.

Bond investors won’t celebrate
On the other hand, a stronger labor market—which supports consumer spending and keeps US economic growth up—is clearly a major contributor to the Fed’s patience on rate cuts. That’s great for central bankers, becoming more worried about sticky inflation and inclined to keep rates up, because it means they’ll worry less about overly restrictive policy crushing American workers. It’s obviously less great for bond investors, who’ve watched Treasury yields rising in recent weeks as the timeline for Fed easing looks like it’s getting longer.​

US Dollar Strength

Greenback looks unstoppable
Last week, we made a passing reference to dollar strength in the wake of Donald Trump’s reelection. But it’s obviously not just “America First” policies like tariffs and mass deportations influencing the US currency’s strength. Everything we’ve said above about Fed gradualism—not to mention all of the economic data supporting it—plays into keeping the dollar in a position of strength after a post-election surge that has seen the DXY index, tracking USD versus a basket of major currencies, up 3% since the November 5th: a big move in the world of FX trading!

Growth worries hit EUR, GBP
Things get more complicated when one unpacks USD strength, breaking things down with respect to individual currencies (see below). Among developed markets, weakness in the euro and pound reflect especially serious concerns over the European and UK economies. The euro’s losses coincide with severe divergence between expectations for ECB easing—confronting fears over slower growth—and a more conservative pace of Fed rate cuts; with pound was likewise hit hard by a poorly received Labour party budget and third-quarter GDP showing lower-than-expected growth.

EM currencies also slipped
Among emerging economies, the South African rand was one of the worst performers against the dollar since Trump’s win, with local economic challenges exacerbating the repricing of risk that Fed policy will turn out to be higher-for-longer, after all. Countries likely to be more affected by tougher trade policy—including China, but also Taiwan, Korea, and Mexico—have seen their currencies slip, with pundits expecting the latter to fare particularly poorly as hopes of a boost from nearshoring give way. The rupee, tightly managed by India’s central bank, has been a shelter in the storm.

Could AI give USD a boost?
At the UBS European Conference last Thursday, one of the bank’s portfolio managers, Evan Brown, offered up another reason to believe dollar strength will persist: artificial intelligence. Mr. Brown, Head of Multi-Asset Strategy at UBS Asset Management, said that “the global implications of AI development and the spillovers are likely to be disproportionate toward the US than to other countries”. Judging by global investors’ appetite for shares of NVDA as its price target rises, as much of a stretch as this seems, there may be some truth in it!
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