- Economists expect core inflation to have slowed to 0.3% in June.
- A precipitous fall in used-vehicle prices further lowered expectations, making a 0.2% desired for investors.
- Core CPI of 0.4% or higher would trigger a market sell-off.
Less cash for clunkers – a plunge of 4.2% in costs of old vehicles in June has been lifting market spirits ahead of the all-important Consumer Price Index (CPI) release. That means that economists' expectations of a deceleration in underlying inflation to 0.3% MoM is no longer good news.
Will markets sell the fact? That is one scenario out of three, in this preview for US CPI for June, due out on July 12 at 12:30 GMT.
Why inflation and Core CPI are so important for markets
After years of focusing on the labor market, inflation lifted its ugly head in 2021, and central banks have focused on curbing it. The US Federal Reserve (Fed) has limited impact on energy and food prices, which are set on global markets, and focuses on Core CPI, which excludes these volatile items.
While headline CPI decelerated to 4% YoY in May – and is expected to continue slowing down to 3.1% YoY in June – Core CPI remained stubbornly high, raising at 5.3% YoY, and expectations stand at 5% YoY for the upcoming release. The Fed aims for 2%.
To check if progress is being made, the Fed and markets zoom in on the monthly change. After rising by 0.4% in May, the economic calendar shows a forecast for 0.3% in the upcoming read. That is still elevated, as a monthly read of 0.3% represents an annualized increase of roughly 4%.
Core CPI developments:
Source: FXStreet
Based on data and statements from officials, bond markets are pricing a rate hike in the next Fed meeting on July 26, but the next moves are uncertain. The central bank's projections pointed to two increases in borrowing costs – as always, such a move depends on the data.
Why markets are optimistic ahead of the inflation release
On Friday, the Nonfarm Payrolls report missed economists' estimates for the first time in 15 months, albeit still showing a decent increase of 209,000 new positions. Fed Chair Jerome Powell stressed the importance of labor-related inflation, and the cooldown in hiring encouraged investors. However, the stubborn increase of 0.4% in wages limited the party.
And on Monday came Manheim.
Source: Manheim
Manheim publishes America's most prominent index of used vehicles, and it showed a considerable drop of 4.2% in the cost of clunkers in June, and 10.3% YoY. Cars are big ticket items, having an outsized impact on the overall CPI and Core CPI.
That shapes expectations for Wednesday's release.
Three scenarios for the market reaction in the US Dollar, Gold and stocks
1) As expected: An increase of 0.3% in Core CPI MoM is fully priced in, and would only serve as a confirmation of what markets had expected since Monday. I expect the US Dollar to jump, Gold to retreat and stocks to stumble.
Will such a risk-off reaction hold? Probably not. A deceleration in prices is still good news, and investors will likely continue pricing out a second additional rate hike. The broad trend of the Greenback is down, and for stocks, it is up.
A "buy the rumor, sell the fact" knee-jerk reaction could serve as an opportunity to join the overall trend. This is my baseline scenario.
2) Better than expected: A welcome slowdown of Core CPI to 0.2% MoM or weaker would be what markets are craving. It would provide firmer evidence that the inflation genie is getting back to the bottle.
The US Dollar would fall in such a scenario, while Gold and stocks would advance. A 0.2% read would likely trigger a moderate move, and any number lower than that could result in euphoria.
The probability is lower than the previous scenario.
3) Worse than expected: A read of 0.4% or higher would be disappointing, showing that while prices of goods such as cars are down, costs of labor-intensive services and even housing are refusing to come down. It would raise expectations for a second post-pause Fed hike.
In such a scenario, the Greenback would stage a massive comeback, while Gold and stocks would suffer. It would cause a rethink. I see this scenario as the least likely, but it cannot be ruled out.
Inflation FAQs
What is inflation?
Inflation measures the rise in the price of a representative basket of goods and services. Headline inflation is usually expressed as a percentage change on a month-on-month (MoM) and year-on-year (YoY) basis. Core inflation excludes more volatile elements such as food and fuel which can fluctuate because of geopolitical and seasonal factors. Core inflation is the figure economists focus on and is the level targeted by central banks, which are mandated to keep inflation at a manageable level, usually around 2%.
What is the Consumer Price Index (CPI)?
The Consumer Price Index (CPI) measures the change in prices of a basket of goods and services over a period of time. It is usually expressed as a percentage change on a month-on-month (MoM) and year-on-year (YoY) basis. Core CPI is the figure targeted by central banks as it excludes volatile food and fuel inputs. When Core CPI rises above 2% it usually results in higher interest rates and vice versa when it falls below 2%. Since higher interest rates are positive for a currency, higher inflation usually results in a stronger currency. The opposite is true when inflation falls.
What is the impact of inflation on foreign exchange?
Although it may seem counter-intuitive, high inflation in a country pushes up the value of its currency and vice versa for lower inflation. This is because the central bank will normally raise interest rates to combat the higher inflation, which attract more global capital inflows from investors looking for a lucrative place to park their money.
How does inflation influence the price of Gold?
Formerly, Gold was the asset investors turned to in times of high inflation because it preserved its value, and whilst investors will often still buy Gold for its safe-haven properties in times of extreme market turmoil, this is not the case most of the time. This is because when inflation is high, central banks will put up interest rates to combat it.
Higher interest rates are negative for Gold because they increase the opportunity-cost of holding Gold vis-a-vis an interest-bearing asset or placing the money in a cash deposit account. On the flipside, lower inflation tends to be positive for Gold as it brings interest rates down, making the bright metal a more viable investment alternative.
Final thoughts
The CPI report is critical for financial markets, often triggering more volatility than Nonfarm Payrolls. Manheim's report caused some market mania and clearly skewed expectations toward a lower, more favorable outcome.
A 0.3% read on Core CPI MoM would trigger a temporary disappointment, while outcomes above or below this figure would also cause significant volatility. I suggest trading with care around the release, which tends to result in choppy price action.
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