Inflation data and new US settlement rules to dominate sentiment

Risk sentiment has faltered in recent weeks, and global stock markets have experienced a mild sell off, as the focus shifts to a plethora of economic data that is released this week. The focus will be the Eurozone’s first reading of May CPI and the US core PCE index, both released on Friday. This data may tell us if the market has been too quick to price out rate cuts for this year, if yes, then we could see risk sentiment improve later this week.

Good news on UK inflation

Earlier on Tuesday the UK’s BRC shop price index for May came in weaker than expected at 0.6% YoY. This is the lowest level since late 2021 and is further evidence that inflation in the UK is rapidly normalizing after remaining elevated between 2022 – 2023. This index tracks 500 of the most bought products across retail stores in the UK. Thus, it is a good indication of shop price inflation. This reading was lower than expected, analysts had expected a reading of 1%, and it might go some way to negating the higher-than-expected CPI inflation reading for April. The April inflation report triggered a selloff in UK Gilts and it also led to a rapid repricing in the UK interest rate futures market. As we have mentioned in previous notes, the fact that central bankers remain data dependent is causing volatility in financial markets, as traders react to individual data points rather than look for trends and themes in the data.

UK inflation could weaken further in May

The weaker shop price inflation is another sign that goods prices in the UK are falling sharply. The BRC reported that nonfood sales remain in deflation, falling by -0.8% in May, a deeper decline than the -0.6% reading for April. Food price inflation moderated to a 3.2% rate in May, down from 3.4% in April. Fresh food prices fell to their lowest level since November 2021 at 2%, below the 3-month average of 2.3%. This is good news for the consumer, especially if they are looking to buy furniture, TVs, or other electronics. However, it highlights the split between falling goods and food prices and sticky service prices, which remain elevated at a 5.9% annual rate last month. Until the service side of the inflation equation starts to moderate more sharply than interest rate cuts from the BOE are on ice.

The BRC data may explain why the pound is one of the weaker currencies in the G10 FX space on Tuesday, and why we have seen the 10-year Gilt yield fall by 4 basis points so far this morning, and the 2-year Gilt yield moderate by more than 5 basis points. European stocks are mostly flat to slightly higher at the start of trading on Tuesday, and US futures are indicating a positive open for the US markets later.

T+1 settlement rules could trigger some volatility

It is a big day for US equities as it is the first day that new T+1 settlement rules come into force. This means that from today stock trading in New York will have only 1 day to settle trades, the first time the settlement has been a single day for 100 years. Before today’s change it was 2 days, and prior to 2017 it was 3 days to settle a trade. There are concerns about teething issues, for example, ensuring international traders can source enough dollars in time and less time to fix any errors. Ultimately the idea is that a shorter settlement time will reduce risk in the financial system, as a shorter settlement time means that there is less chance of something breaking in the settlement period. The biggest risk is the FX impact, especially if there are large flows from overseas into US stocks. These traders/ funds will need to source dollars faster, or ahead of their trade, since FX markets typically settle in 2 days. Thus, the mismatch could trigger cancelled trades and potential volatility in this early phase. The big risk comes on Wednesday, when the plumbing system at the NYSE will need to deal with Tuesday’s settlement date, and Friday’s settlement date at the same time. This Friday, there is also the MSCI rebalancing to deal with, which could lead to a surge of orders and less time to process them. Banks and the exchanges have been planning this for months, and this week we will see if the machine runs smoothly or if there will be some early missteps. Either way, if you spot large price swings in the US markets for no reason, it is probably an early issue with T+1, that should be rectified.

Overall, if the shorter settlement time in the US goes well, then there is no reason why that would not be rolled out in other countries, and eventually the FX markets may also follow suit.

ECB rate cut expectations hinge on May CPI

Elsewhere, EUR/USD is testing $1.0880, as the market waits for Eurozone inflation data for May. The annual rate of inflation is expected to rise to 2.5% from 2.4%, while the core rate is expected to remain steady at 2.7%. While this is not expected to move the dial for a June rate cut from the ECB, the market is pricing in a 92% probability of a rate cut, down from 96% last week. There are a total of 38 basis points of cuts priced in for the ECB this year, vs. 34 bps of cuts for the Fed this year. While the ECB is expected to cut in June, the prospect of a second cut is up in the air after several ECB members poured cold water on the prospect of back-to-back cuts, although the head of the French central bank said that it could be a possibility.  Thus, the outcome of the Eurozone inflation report for May could have big ramifications for the euro in the short term.

US inflation could shift the dial for the Fed

The market will also be focused on the core PCE reading for April from the US, that will be released on Friday. The market is expecting a reading of 2.8% for the core PCE deflator for April. If this come in line with expectations, it could ease fears about inflation running hot in the US, especially after inflation expectations moderated in the University of Michigan Consumer Confidence report for May that was released on Friday. If we see a weaker than expected core PCE reading, then we believe that the market may rush to reprice a more dovish Fed ahead of the June 12th Fed meeting.