It’s been, now, two weeks since the Fed
Said rate cuts were not straight ahead
Their confidence lacked
Support to abstract
Inflation was finally dead
 
Which brings us now to CPI
Where analysts identify
Used cars and soft gas
As just ‘nuff to pass
The test and wave ‘flation bye-bye

 

Finally, the CPI report will be released this morning so we will be able to collectively exhale!  The current consensus forecasts are for a 0.2% M/M rise in the headline, leading to a 2.9% Y/Y outcome and a 0.3% M/M rise in the ex-food & energy reading leading to a 3.7% Y/Y increase.  Those annual numbers would be down from 3.4% and 3.9% respectively.

A key part of the thesis for the ongoing decline is that Used Car prices will continue to fall as well as gasoline prices, which fell about 30 cents/gallon on the NYMEX exchange.  However, rent increases remain stubbornly high and any declines in foodstuffs seem to have ended.  There was a ‘brilliant’ article by a UC Berkeley economist, Ulrike Malmendier, that determined most people’s view of inflation was skewed by the prices of things they bought most frequently, rather than the ‘proper’ economists’ view of the totality of prices.  Who would have thunk it?  Honestly, it is hard to believe that some of these people have degrees at all.

At any rate, the market is highly fixated on the number and there is no doubt that many are looking for a soft outcome and, perhaps, sufficient proof for the Fed to gain enough confidence to cut rates in March.  As it stands, right now the Fed funds futures market is pricing a 15.5% probability of a March cut and a 57.5% probability of a May cut.  But the pining for this cut is palpable.  I will reiterate my view that based on the current trajectory of economic data, there is no reason for the Fed to cut at all absent a major downturn.  Clearly, given the government’s ongoing fiscal largesse, economic activity continues to move along.  While price rises have been slowing over time, I would contend there is no risk of a major deflationary event.  

The flip side of this argument is that the Federal government cannot afford to continue with interest rates this high.  Much has been made of the fact that interest payments on the Federal debt are now in excess of $1 trillion per annum, more than either defense spending or Medicare, and trending inexorably higher.  While they remain <5% of GDP, the fact that the government is running a budget deficit of >7% of GDP and slated to do so for the foreseeable future, there will come a time when this process will be unsustainable.  However, as Japan has proven over the past twenty years, things previously thought impossible are not necessarily so if the population tolerates them.  Right now, the major financial problem for the government is not the deficit, but inflation.  So that is where the attention is focused.  Eventually, something will have to give, but it is not clear that will occur within the next several political cycles, and ultimately, that’s the only time things like this will be addressed.  So, look for more of the same for now.

Turning back to markets, ahead of the CPI report, most markets around the world have remained quiet, with one notable exception, Japanese equities which have continued their impressive rally.  After a mixed and lackluster session yesterday in the US, the Nikkei rose nearly 3.0% overnight as the ongoing yen weakness and a growing suspicion that the BOJ is not going to act anytime soon continues to support things there. Chinese markets remain closed all week for the New Year holiday but the rest of the APAC markets had solid sessions.  European bourses, however, are under some pressure this morning with all of them lower by between -0.3% and -0.6%.  The data from the UK showed that the employment situation was better than expected, with lower Unemployment and firmer wage growth.  This will not encourage the BOE to consider cutting rates anytime soon.  As to US futures, at this hour (7:45) they are somewhat lower with the NASDAQ (-0.75%) leading the way down.

Meanwhile, in the bond market, yields have edged lower everywhere except the UK (+2bps and see employment data for explanation) as Treasuries (-2bps) show the way and most of Europe has followed directly in its footsteps with similar yield declines.  Interestingly, JGB yields were unchanged overnight despite the equity rally and yen weakness.

Oil prices (+0.75%) are bouncing this morning as any hopes of a ceasefire in the Middle East have faded for now but we are also seeing broad-based strength across the metals markets with gold (+0.4%), copper (+0.75%) and aluminum (+0.3%) all finding support this morning.  Perhaps this is on the back of dollar weakness in anticipation of a cool CPI print.

Speaking of the dollar, it is broadly softer, albeit not dramatically so.  GBP (+0.4%) is the leading G10 currency although CHF (-0.4%) has fallen on the back of a much lower than expected CPI reading there, just 1.3% Y/Y, with market participants now looking for rate cuts sooner rather than later.  In the EMG bloc, things are mixed although there are more gainers than laggards with ZAR (+0.5%) the leader of the pack on those strong metals prices.

Looking at this week’s data beyond today shows the following:

Thursday	Initial Claims	220K
	Continuing Claims	1880K
	Retail Sales	-0.1%
	-ex autos	0.2%
	Empire State Manufacturing	-15
	Philly Fed	-8
	IP	0.3%
	Capacity Utilization	78.8%
	Business Inventories	0.4%
Friday	PPI	0.1% (0.6% Y/Y)
	Ex Food & energy	0.1% (1.6% Y/Y)
	Housing Starts	1.46M
	Building Permits	1.509M
	Michigan Sentiment	80.0

Source: tradingeconomics.com

As well, today we already saw the NFIB Small Business Optimism Index show a little less optimism printing at 89.9, down 2 points from last month.  Of course, things would not be complete without a bit more Fedspeak, with 6 more on the calendar including Governor Waller, perhaps the 3^rd most important voice there.

Overall, while I don’t think the rate of inflation has much further to fall, and in fact, I expect it to rise again as the spring and summer progress, today’s number feels like it could be soft.  Here’s the thing, the market is anticipating that soft number so it is not clear to me how much further they can drive risk assets higher on this news.  They need something new.  However, if it is hot, look for a sharp down day in risk assets and higher yields and a higher dollar.

Good luck

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