A final rate rise will likely be required to curb inflation, according to Josh Cannington, one of StoneX’s interest rates analysts. The flight to safety trade, which has benefitted dollar assets, is taking a back seat to upside inflation risks, which were still evident in yesterday’s Consumer Price Index (CPI) inflation report.
According to Cannington, stubborn core inflation still exceeds the Fed’s 2 percent target, and expensive housing cost is a significant explanation. The reported CPI data looked reasonable: headline rose at an unchanged 3.7% annual rate in September, while core CPI ex-food and energy fell to 4.1% from 4.3% last month. However, some underlying trends are more worrying.
Headline inflation is growing at a pace that, if sustained, would have the Fed facing 5.0% inflation by year-end in Cannington’s view. The Bureau of Labor Statistics noted that the price index for shelter was the most significant contributor to the monthly increase in consumer prices, accounting for over half of the rise. The ‘Owners’ Equivalent Rent’ category re-accelerated to a 0.6% monthly pace, slowing the year-over-year change from 7.3% to just 7.1%. And it’s not only housing costs, with the ‘super core’ reading of inflation ex-housing seeing the most significant monthly gain in a year, up 0.61% last month.
“The Fed may find solace in the fact that the market is beginning to do some of the heavy lifting in constricting financial conditions,” Cannington observes, “but today’s report reaffirms how tough the last mile to 2.0% inflation will be. Coupled with the 336,000 jobs creation and healthy wages last month, this keeps the Fed on edge.”
Interest rate markets reflect these concerns. Short-dated bonds saw yields rise. Cannington reports that the interest rate futures market traded higher after the CPI print, with the interest rate curve shifting up by 9-10 basis points across all duration periods.
“Perhaps if it weren’t for the recent bear steepening of the curve, lifting financial conditions tighter, the report would have a larger impact on rate hike expectations,” Cannington said. “The CPI report was enough to lift Treasury yields.”
The CME Fedwatch tool, which expresses the probability of a rate hike, points to the much higher likelihood of a quarter-point hike at the December FOMC meeting.
2-year Treasury Yield vs Probability of a Quarter Point Rate Hike
Source: Bloomberg, StoneX.
Interestingly, higher long rates might diminish the need for short rate hikes. A typically hawkish Fed Governor, Christopher Waller, made this recent observation: “The real side of the economy seems to be doing well. The nominal side is going in the direction we want. So, we’re in this position where we watch and see what happens on rates. Financial markets are tightening up, and they will do some work for us.”
However, Raphael Bostic, a dovish Fed Governor, countered that point: “Today, I don’t think we need to do anything more in terms of interest rates, but if inflation stalls out or goes in the other direction, that would be a clear sign we need to do more.”
At last month’s Fed meeting, rates were left unchanged, and Powell signaled that the Fed was almost done hiking rates – but behind the scenes, the focus began to switch to the downside risks. Powell used the word “carefully” 13 times in his post-meeting press conference, and we now know from yesterday’s release of the September FOMC meeting minutes that all Fed officials agreed that they should “proceed carefully” on rate decisions. It will be interesting to see if the official rates have peaked or if we get one more increase. Bond and money markets are leaning towards the idea of one last increase.
Analysis by Josh Cannington, Vice President, Interest Rate Derivatives. [email protected]
Reported by Paul Walton, Financial Writer: [email protected]
