US inflation cools

13 January 2023

Please note: The article does not constitute advice or any form of investment recommendation. All numbers quoted were sourced from Bloomberg data as at Thursday 12 January 2023. Past performance is never a guarantee of future performance.

Latest figures in the US suggest that the sting has finally been taken out of inflation. 

The US consumer price index (CPI) reported an annual increase of 6.5% in December 2022, which while still uncomfortably high, nonetheless represents a solid drop from 9.1% posted in June.  

The inflation print triggered a positive price action in the bond market, with the US 2-year yield retreating to 4.12% from 4.25%. Meanwhile, the 10-year yield declined to 3.43% at the lows. 

Forward rates now imply a softer hiking path by the US Federal Reserve (Fed) with a higher chance for a 25-basis point (bp) hike instead of 50bp in February’s rate-setting meeting, with a peak upper target for US interest rates at just below 5%.  

In a continuation of the so-called ‘disinflation party’, the corporate bond market also reacted positively, as spreads for high yield and investment grade debt tightened, bringing down the overall yield.

What’s driving the decline? 

The recent moderation in core CPI largely reflects deflation of core goods over the last three months. In December, core goods prices fell for a third consecutive month, declining by 0.3% month-on-month (M/M), resulting in the 3-month annualised percentage change declining from -3.5% to -4.8%. 

A sharp decrease in used car prices (-2.6% M/M) was influential in the latest data, while new car prices also fell for the first time since January 2021. Interestingly, “super core” inflation – in other words, CPI all items less food, energy and shelter components - turned negative (-1%) on a 3-month annualised basis. This is key as the shelter component, which makes up a third of the overall CPI basket, has yet to reflect the sharp drop we’ve seen in housing demand. In other words, there is not much left to support elevated inflation. 

The Fed remains heavily scrutinised

As we covered in a recent article – Fed’s 2022 finale: A hike, obviously –  there is a high degree of uncertainty about what lies ahead for the US economy, and therefore for the world economy, this year. That said, weaker inflation supports the broad consensus that any recession could be relatively shallow and short-lived.  

In the aftermath of yesterday’s CPI release, the disinflationary mood was further supported by softer Fed speak. Philadelphia Fed President Patrick Harker was quoted as saying that 25bp steps “will be appropriate going forward”1

The easing in core inflation in particular, seems to reduce the pressure on the Fed to keep on the steep hiking path seen in 2022. While wage growth remains at the higher end and the job market is still tight, there are signs that hiring is slowing. Yet, the Fed would surely like to see more evidence of cooling inflation before halting hikes (or thinking of cutting the policy rate).  

Richmond Fed President Thomas Barkin echoed this view, pointing to an interest-rate path that is “slower, but longer and potentially higher”, as well as, “one that reacts to inflation”2

Final thoughts 

From the peak, the rate market is pricing in roughly 50bp of cuts by year end. At this point, this does not seem on the Fed’s agenda and would potentially be more dependent on the weakness of the US economy than on inflation. 

While this uncertainty may be a breeding ground for rate volatility, once the disinflation rally abates, the question remains if this is enough to bring back the yield peaks seen in October.  

We will continue to share our insights over the coming months, and our monthly Market Perspectives report returns on 6 February 2023.  

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