Inflation continues to fall in the US. The CPI for May has shown that as the sharp jump in price over the first half of 2022 continues to drop out of the data, inflation is decisively falling. This disinflationary path leaves me questioning the Fed’s next move after the pause in the FOMC hikes in June. The narrative will likely be around it being a “skip” and perceived as a hawkish hold. However, moving forward as the data points to a slowdown this could now be an extended pause.
- US inflation continues to fall
- Expect tough talk but the peak in rates may already be here
- The US dollar reaction to a “hawkish hold” may be positive, especially on USD/JPY
- US equities love the growing potential for peak rates, or at least, big tech does.
US CPI on a disinflationary path
The US CPI data for May shows that inflation is falling in the US. The disinflation may not be as fast as some would wish, but it is moving lower. Headline CPI increased by just +0.1% MoM meaning the YoY reading dropped to 4.0% (from 4.9%). On a core basis, CPI is higher, increasing by +0.4% MoM but the YoY measure was a little more sticky in a drop to 5.3% from 5.5% in April.
However, inflation will continue to fall in the coming months. Next month there is a huge +1.2% MoM from June 2022 that will drop out of the YoY calculation. For core CPI, there is a +0.6% MoM reading to also drop out. Subsequently, next month’s YoY CPI readings for June will likely show further significant declines.
Now, there will be come on the FOMC that will be arguing that inflation is not coming down fast enough. Certainly, if you consider the core PCE (the Fed’s preferred inflation measure) the rate of decline is far more stubborn. I will also be watching the US Core PPI today. The PPI has been leading the decline in the US CPI but is forecast to tick slightly higher in May.
The Fed is on pause, but tough talk will do the heavy lifting, for now
The Fed will almost certainly pause its hiking cycle today by holding rates steady in today’s June FOMC meeting. The question then becomes whether it will be the end of the tightening. My opinion is that Powell will talk tough, perhaps by saying “this is not the end of the monetary policy tightening”. The dot plots may even be revised higher.
However, the reason why the Fed is pausing is to assess the impact of the most aggressive policy tightening in four decades. In the next six weeks until the July FOMC (when supposedly they could resume hiking), the data will show continued inflation reduction (on the CPI at least). The May jobs report showed a sharp jump in unemployment. Bank lending has slowed dramatically. The arguments are racking up for an extended pause (i.e. the peak of the rate hikes). Furthermore, the end of most tightening cycles comes with the Fed still talking about further rate hikes being needed.
However, for markets, this tough talk, we could call it a “hawkish hold” will do the heavy lifting for the initial market reaction over the coming days. It will likely prevent yields from dropping too sharply and should help to prevent a slide in the USD. I favour looking at playing USD/JPY on the long side. However, as ever it would seem, the big winners though could be that the juggernaut of a rally in US indices just keeps on going.
USD/JPY is the major pair to watch
A hawkish hold from the Fed will likely drive an initial USD positive reaction. With Fed decisions so important for the path of Treasuries, the key mover in USD pairs is often the USD/JPY. Looking at the forex chart for technical analysis, it seems that a recent consolidation is preparing for an upside break.
The May rally has consolidated in the last two weeks. This comes after the completion of a six-month reversal pattern. The near-term unwind is around the good support of the base pattern which comes around 137.65/138.45. Momentum has also unwound with the daily RSI holding around the 60 level. This looks to be a potential bull flag forming. A closing breakout above 141.00 would open the upside once more.
E-mini S&P 500 futures continue higher
The run higher in US index futures has been incredible. A hawkish hold from the Fed would be unlikely to change this. Since breaking out above the key resistance band between 4171/4227 the market has barely looked back.
I have written extensively about the lack of breadth in this market rally and this will eventually catch up with the move. However, for now, the importance of the big tech stocks that continue to rally decisively is overriding any sense that overbought conditions might take hold. Leaving the 4327 August 2022 high in its wake, the upside is now open to a test of the 4631 March 2022 high. Technically, momentum is looking stretched on the RSI, but this can come with the strength of this rally. Certainly, for now, this move looks set to continue higher. A pause from the Fed may just give a boost to this.
