June’s CPI and PPI reports surprised to the downside, reducing the risk of an imminent Fed hike and pulling two-year Treasury yields lower. New York Fed President John Williams’s view that policy is well positioned and that inflation has likely peaked reinforces the case for policy remaining on hold.
With markets still pricing some tightening later this year, and a potential resolution in the Strait of Hormuz offering an additional disinflationary catalyst, we see further downside for front-end yields.
Inflation Falls MoM
June’s inflation data delivered a favourable one-two punch.
Yesterday, headline CPI fell 0.4% month-on-month, lowering the annual rate from 4.2% to 3.5%, while the important core CPI measure was unchanged on the month and eased to 2.6% year-on-year.
Today’s PPI report reinforced the message, declining 0.3% against expectations for a flat reading, with the core measure also softer than forecast.
Energy Important Factor
Energy was an important contributor to both releases, but the moderation in core consumer prices and underlying producer-price measures suggests that the improvement was not exclusively an oil story.
By some accounts, the combination of these reports should allow core PCE to round down to 3.3% in June, reducing some pressure from the Fed to hike in the near term. Unsurprisingly, the front end rallied in response, with the two-year Treasury yield falling more than 10bp with both reports, as investors reduced the probability of a July hike to nearly zero.
Williams on Inflation
New York Fed President John Williams argued that inflation has probably peaked and should decline over the coming quarters. Although Williams stressed that inflation remains too high, the assessment that current policy is ‘well positioned’ (alongside expectations that tariff effects, shelter inflation and oil-price pressures will moderate) supports the notion that the likelihood of a near-term rate hike is quite low.
Looking ahead, we believe front-end yields have further room to fall.
Rates Price in Risk
Rate markets continue to price a meaningful risk of additional Fed tightening later in the year, leaving scope for repricing as markets converge with our view that the Fed will stay on hold.
Hormuz Opening Would Help
A clear and definitive resolution of the disruption around the Strait of Hormuz would strengthen this case: lower crude oil and freight costs would mechanically reduce headline inflation, ease upstream price pressures, and encourage markets to reprice policy expectations more dovishly.Â
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