US inflation cools and banks see profits surge

US stock index futures have surged on the back of an improvement in core inflation in the US. Dow Industrial Average futures are pointing to a 580-point gain at the open, while the S&P 500 futures are suggesting that the index could open within touching distance of 6,000. A lot was resting on the US CPI report for last month, and after an improvement in core inflation, global asset markets are taking a sigh of relief.

Although headline CPI jumped to 2.9%, this was expected by analysts and it was mostly down to a surge in gas prices, after a volatile few weeks for the oil price. More importantly, the core rate of inflation, which the Fed uses to decide monetary policy, eased back and fell to 3.2% from 3.3% in November, analysts were not expecting a slowdown in the core rate of price growth. Wage data that was released alongside the CPI report showed that real average weekly earnings retreated to a 0.7% annual gain in December, down from 0.9% in November. Real average hourly wage gains also slowed down in December to 1% from 1.3%.

Digging deeper into this report, although headline inflation was higher, this was down to food prices and a sharp rise in monthly gas prices, which saw the energy sector contribute 0.1% to monthly headline CPI, its largest contribution for more than a year. The Fed could choose to look through price increases for volatile commodities that they cannot control. Instead, the Fed may focus on core inflation. There was good news on this. Core services made up the bulk of core inflation last month, while core goods inflation was flat. While service prices continue to increase and make up the bulk of US core price pressures, service prices trended lower at the end of 2024, which is encouraging for future Fed rate cuts.

The compound effect of the US and UK CPI reports, which were both better than expected, has had a profound effect on the bond market. US 10-year Treasury yields are lower by 12 bps, in the UK the 10-year Gilt yield is down by 15bps. The short end of the yield curve has also benefitted, with the 2-year yield lower by 10bps in the US and by 14 bps in the UK, as investors rush to price back in interest rate cuts from the BOE and the Federal Reserve.

The market is now expecting US interest rates to end this year at 3.93%, yesterday the expectation was for yields to end 2025 at 4.03%. The market is still not willing to price in a second rate cut for the Fed this year, however, the chance of a rate cut in May has increased on the back of this report. In the UK, the market is expecting just over 2 rate cuts this year. The probability of a rate cut in February is now 87%, suggesting that the market sees the improvement in UK inflation, especially service price growth, as the key to unlocking further rate cuts down the line.

These CPI reports have impacted financial markets broadly, the pound is staging a strong recovery, and the US dollar is the weakest currency in the G10 FX space today. GBP/USD is rallying on Wednesday and is testing resistance at $1.23. The recovery in the pound on the back of better-than-expected UK CPI report is down to a few things: 1, foreign investors may be attracted to UK debt, which is attractively priced. 2, the improving picture for inflation takes the UK a step away from a fiscal crisis, and so the reduction in the UK’s crisis premium, is benefitting the pound.

Stronger than expected bank earnings is also having a positive effect on markets. JPM, Goldman Sachs and Citi all reported strong earnings on Wednesday. As expected, their investment banking and trading units saw profits surge due to the boom in trading activity around the US election. GS and JPM reported stellar earnings. GS profits doubled compared to a year ago, and JPM benefitted from what it called an ‘animal spirits moment.’ Both banks also gave strong outlooks. Citi’s shares are also higher by more than 5% even though it is still making progress with its strategic turnaround plan. Overall, there was not much to dislike in the bank earnings reports and the KBW US banking index may stage a recovery in the coming days on the back of these results and positive outlooks.

Overall, risk sentiment is high, investors are breathing a sign of relief that interest rate cuts could be back on the table. There are still issues in the bond market. The UK and the US still have deficits that are too high for comfort. Also, markets do not only rally on the back of economic data, but they also move on the back of economic policy. The markets are worried about Trump’s tariffs ahead of next week’s inauguration, and it is too soon for Rachel Reeves to take a victory lap, as the bond market is likely to keep the pressure on her after giving a damning verdict on her economic policy decisions so far and on the increased UK debt issuance. But today, is all about recovery in the bond market.