The CIO’s Take:
Crucial data for next FOMC
Fed policy, as we’ve mentioned before, is one of the biggest drivers of investors’ sentiment toward stocks and bonds at this point—and the implications go well beyond US markets as we’ll explore at the end of this week’s commentary. In discussing the decision-making going on at the US central bank recently, we’ve noted that what happens in September will largely depend on the data Fed officials receive leading up to that meeting. Front and center are two US inflation reports covering July and August, the first of which hit the tape last Wednesday.
July CPI falls, as expected
Data from the Bureau of Labor Statistics (BLS) showed headline CPI increasing 0.2% month-over-month, and though that was up from a 0.1% decline in June’s CPI, it was in line with economists’ expectations and corresponded to 2.9% year-over-year growth in prices: a tick below June’s 3% inflation rate, and the lowest reading since March 2021. After a weaker-than-expected July jobs report, seeing disinflation firmly back on track should, in our view, give the Fed confidence enough to begin easing in September.
Shelter is the last big hurdle
Getting into the details of July’s numbers, the rise in prices was primarily a result of two factors: shelter costs, which popped 0.4% month-over-month, and car insurance, up 1% since June. That increase in the shelter category was enough to explain almost 90% of the monthly rise in CPI. Indeed, as the chart below illustrates, it’s really only shelter costs at this point keeping headline inflation above the Fed’s bogey.
Of course, people do pay rent, so we obviously don’t want to underappreciate shelter costs in the calculation of CPI, though it’s perhaps comforting to look at this as a single element of consumers’ basket of expenditures standing between the Fed and its mission accomplished.
Won’t stop September cut
So, along those lines, when might we see that final nail in the coffin for pandemic-era inflation? Because the BLS calculation of shelter costs results in a roughly half-year lag, it could take some time. On the bright side, the Fed is aware of this, with chair Jerome Powell, himself, noting back in June that recent years’ imbalances “may take…several years” to work themselves out. All in all, despite sticky shelter costs, we don’t see anything in the July inflation data to stop the Fed from a 25 bps cut at its September FOMC.
Traders lose faith in half-point cut
So, why not 50 bps of easing in September? Traders clearly felt that was a likelihood in early August, bidding futures to prices that implied a 96% chance the Fed would cut four times in a span of three meetings (see below). Since then, futures traders have backed off such optimistic predictions, with prices as of last Friday indicating just a three-in-five chance of a jumbo rate cut before year-end. You can blame last week’s US retail sales number for a big part of that dramatic revision in expectations.
The prior basis for beliefs in a super-sized rate cut or a move between FOMC meetings was fear in traders’ minds that the US was headed off the cliff into a recession. That’s a topic we touched on in our description, last week, of the ‘Sahm rule’, which makes just such a prediction. Readers might remember our skepticism that the US economy was really that weak. According to US Commerce Department data released last Thursday, our doubts were warranted.
Consumers aren’t spent yet
Retail sales in the month of July totaled 1% more than those in June, the biggest increase since early last year, and well ahead of consensus estimates for a 0.4% rise. Motor vehicle and parts dealers, electronics and appliance stores, and food and beverage outlets accounted for the biggest part of consumers’ increase in spending. That first category is something we tipped as likely to drive jump in spending last month, as June’s cyberattack on dealerships gave way to a July comeback. Even excluding spending on vehicles and parts, retail sales climbed 0.4% for the month.
Stocks, yields rise on the news
We never thought the September cut would be of the half-point variety, so it will come as little surprise that we agree with yield traders’ assessment: barring something very surprising in August’s data, signs the American consumer is not coming undone should cement the Fed’s case for just a quarter-point of easing next month. Stocks cheered the news, while policy-sensitive two-year Treasury yields climbed back above 4%. We expect chairman Powell will have plenty to say about the data above when he speaks in Jackson Hole at the end of this week.
Fed policy moves currencies
Earlier in this week’s commentary, we noted that the consequences of September’s FOMC ripple out to our readers’ global investments, and that has been readily apparent looking at foreign currencies, where Fed policy exerts a hefty influence through its relationship to the strength of the US dollar. That’s because high US rates make the yield on dollar-denominated investments like US Treasuries more attractive to global investors, leading to inflows that result in FX traders bidding up the price of the greenback versus other foreign currencies.
FX traders react to recent data
As such, though we don’t always comment on it explicitly, whenever data like US CPI and retail sales hit traders’ screens, there’s an immediate impact on exchange rates around the world. When the data strengthen the case for Fed cuts, as they did last week, the result is generally a weakening of the dollar. When the Fed gets hawkish, by contrast, or when policy is simply uncertain and investors make a flight to safety, demand for dollars rises and USD appreciates against the basket of global currencies.
EM currencies pricing a pivot
That dynamic is crystal clear in the chart below, plotting the dollar against a basket of emerging markets’ currencies—especially sensitive to US rates—showing massive USD strengthening from the point at which rate hikes began, in early 2022, second only to a panicked flight-to-safety at the outset of 2020’s COVID pandemic (see below). Since late-2022, we’ve seen a solid reversal of the dollar’s gains, as investors look ahead to inevitable Fed easing as US inflation moves back into check.
Growth and politics matter, too
Other things move currencies, of course. While a number of EM currencies traded down against the dollar last Thursday, as hopes for really big cuts subsided, the Mexican peso did quite well, appreciating by 0.9% against the dollar. That’s because, as America’s biggest trading partner, the prospect of greater trade in the event of a soft landing was deemed the bigger prize. Likewise, we reckon part of the recent slide in USD is attributable to Trump’s struggles in the polls since Harris replaced Biden for the Dems (recall the ‘Trump trade’ called for bets on a stronger dollar).
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