Market Briefing: Softer US inflation sends dollar lower

Markets are doubling down on “soft landing” bets this morning after US consumer inflation slowed as expected, reducing the need for further monetary tightening from the Federal Reserve. Equity futures are up, Treasury yields are down slightly on the front end of the curve, and the dollar is slipping ahead of the North American open.

North America

Headline consumer prices rose 3.2 percent in July from the same period last year according to data published by the Bureau of Labor Statistics this morning, up 0.2 percent on a month-over-month basis. This was slightly below the the 3.3 percent and 0.2 percent consensus forecasts among economists polled by major data providers ahead of the release. The more closely-watched core measure -  used because it excludes highly-volatile food and energy components - rose 4.7 percent year-over-year, gaining 0.2 percent over the prior month, and hitting consensus economist forecasts precisely on the nose. 

This marks the second consecutive 0.2-percent monthly print, with inflation hitting its slowest pace in two years as used vehicles, airline fares, and medical care costs lost momentum. Owner’s equivalent rent, a largely-theoretical measure of shelter costs, accelerated slightly to 0.49 percent in July from 0.45 percent in June, but other housing cost measures have generally weakened in the last six months, suggesting that policymakers won’t be alarmed.

Consumer Price Indices, Annual Change, %, NSA

This summer’s sharp increase in oil prices could drive headline price measures higher in August and September, but the Federal Reserve is unlikely to respond with additional rate hikes. The underlying inflation gauges historically preferred by policymakers - the core personal consumption expenditures index and the employment cost index - have trended lower in recent months, and households and market expectations remain well anchored. Prior to this morning’s release, investors were convinced the central bank’s tightening cycle was over, and swap-implied odds on a September hike are pushing below 15 percent as we go to pixels - with the first rate cuts priced in for early 2024. This outlook is unlikely to change materially in the absence of a sustained push higher in core prices over the coming months.

Separately, the number of initial claims for jobless benefits hit 248,000 last week, above the 230,000 expected, but still consistent with a remarkably-tight labour market. Continuing claims fell to 1,684,000 in the week.

We think Mexico’s central bank will leave its benchmark lending rate unchanged and deliver a higher-for-longer message in this afternoon’s decision. Yesterday’s July numbers showed year-over-year core inflation running at 6.64 percent, down from 6.89 percent in June, but well above Banxico’s 3-percent target - and the economy has been performing well, with strong consumer demand and rising business investment helping sustain activity levels that could fuel persistent price gains. This could put policymakers at odds with markets that are currently pricing rate cuts beginning within months, and might lead to a more hawkish tone emerging in the forward guidance contained in the accompanying statement. This should keep expected policy rate differentials largely intact, limiting the likelihood of a peso reversal for now (we expect weakness to return later in the year). 

Policy rates, %

Europe

European gas prices jumped almost 40 percent yesterday as rumours of strike actions by workers at liquefied natural gas plants in Australia threatened to disrupt global seaborne supply dynamics. A cold winter and global supply constraints could cause havoc later in the year, but storage levels within the bloc have broken seasonal records and the euro isn’t showing signs of stress - suggesting that traders consider another energy shock relatively unlikely.

European gas storage levels by week, % full

Asia Pacific

Japan’s yen fell back through the 144 mark against the dollar overnight as traders adopted an increasingly bearish view on rate differentials relative to the dollar and euro. With domestic inflation pressures remaining subdued and a slow-motion energy terms-of-trade shock beginning to emerge, the Bank of Japan is seen preserving existing policy settings for longer, maintaining the yen’s deep yield discount and keeping pressure on the exchange rate.

The Chinese yuan remains weaker after data earlier in the week showed weak domestic demand tipping the economy into deflation, raising the likelihood of additional monetary easing moves from the policy apparatus. The headline consumer price index fell 0.3 percent in July from a year earlier, and producer prices dropped 4.4 percent, with declining property prices, weak consumer sentiment, and falling exports combining to weaken upward pressure on prices. This might be expected to drive US inflation lower, but the share of personal consumption expenditures spent on goods ultimately made in China was just 1.7 percent in 2017, and has likely risen only marginally in the years since.

Estimated share of US personal consumption expenditures, %, 2017

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