A moment of relative calm across markets as this week’s US inflation number starts to be taken for granted.
US inflation has ramifications across the world, more directly than most data. As it is likely to move the needle on US bond pricing in a sustained manner.
The actual inflation number often follows the lead provided by inflation expectations. That number, released yesterday, showed a comfortable decline from 4.7%, to 4.4% in April. The drop was largely driven by high education and food. Though expectations for gasoline prices accelerated to 5.1%.
Continued moderation of US inflation, and elsewhere, is of course expected. Nevertheless, the Federal Reserve remains highly focussed on defeating sustained high inflation at any level. To avoid as it terms, the anchoring of high expectations among consumers.
Markets should in general be buoyed going into the inflation number, but seem to be losing some energy just at the moment. Which is a little surprising.
We have certainly seen significant volatility of late, and the drive back up from last week’s sell-off was impressive.
If the market is truly in the mood to continue that rally, then we would expect prices to remain firm before and after inflation results.
There is of course on-going risk in core inflation which has been steadily advancing. Up until now, the market has chosen to ignore that aspect, but could this be about to change.
As Goldman Sachs and Bank American have finally joined our long held view that there are unlikely to be rate cuts this year, or at least the market was getting this aspect of the cycle wrong in magnitude.
This inflation number could have far greater ramifications for the long term outlook for bond pricing than many currently anticipate. Which very much matters for the state and health of the US banking system.
Large numbers off US banks failed to hedge their bond exposures correctly, because they believed like most investors what they wanted to believe, that the Fed would be magically cutting interest rates this year.
It is only just dawning on markets that rate cuts are not likely after all. Something we have been highlighting all along.
The next phase of realisation will come in a few months time, that the Fed may in fact keep rates at these elevated levels for the foreseeable future. Perhaps through 2024 and beyond.
The view here is that should inflation prove stubborn at lower, but still uncomfortable levels, the next rate move after a very long pause, may in fact be to hike rates again. Which goes completely against all the current sentiment on the matter, but is in fact a very possible outcome of this low growth / high core inflation environment.
This will bring great pressure to bear on the US banking system. The fractures and fissures are already plain to see for all.
The highly misguided policy of guaranteeing deposits at only the major banks will remain a constant under pinning and potential further ignition point for a fill scale crisis.
Should bond yields remain at current levels and continue to grind higher, as expected here, then the full recipe is still in place for a much more severe and widespread crisis later this year.
While the market has adopted a pattern of pricing a banking crisis one day, only to reverse as if there is no crisis the next, the underlying realities of depositor withdrawal and bond holdings not marked to market, continue to eat away at the very foundations of the system.
It is in this context that we are about to get both the headline, and the detail of the latest US inflation data. While many are taking a declining number for granted, it could yet be a powerful pointer to far much more than just the cost of goods and services.
Market commentary from Clifford Bennett, chief economist at ACY Securities
