‘Core’ US inflation number key to Federal Reserve rate hikes

US inflation eased from four-decade highs to 8.5 per cent in July on lower energy and fuel prices, sending Wall St higher, but the core inflation is steady, which may trigger more rate hikes.

US inflation eased from four-decade highs to 8.5 per cent in July on lower energy and fuel prices, sending Wall Street higher, but the core inflation is steady, which may trigger more rate hikes.

The annual rise was down from 9.1 per cent in June as price pressures abated across energy categories.

Core CPI, which excludes often volatile energy and food prices, eased to 0.3 per cent last month, down sharply from June’s 0.7 per cent rise.

The annual core inflation rate held at 5.9 per cent.

US stocks rallied after the CPI data was released.

Analysts had expected headline CPI to cool from a four-decade high above 9 per cent. But the more important core CPI was expected to rebound above 6 per cent.

Persistent US inflation may keep up the pressure on the Fed to deliver another outsized rate hike and it could even scuttle hopes of rate cuts next year, barring another financial crisis.

US 10-year Treasury bond yields plunged from a decade high of 3.5 per cent in mid-June to a four-month low in early August of 2.51 per cent on the back of less-hawkish rhetoric from Fed officials and the perception that bad news on the US economy was good news for the interest rate outlook.

Wednesday’s strength in Australian banks was inconsistent with a market poised to peak.

ANZ rose 3.4 per cent to a nine-week high close of $23.46, with Credit Suisse telling clients it was “unloved” and “under-owned”. Other banks followed with Westpac and NAB both up 1.4 per cent, and CBA mostly recovering from a 1.2 per cent intraday fall on slightly disappointing net interest margins.

After plunging 22 per cent from April to June, the banks have bounced about 16 per cent in two months.

The market may well have been short, and ANZ has acquired growth with its purchase of Suncorp Bank, but nothing has improved in terms of the fundamental outlook.

Still, the ASX 200 fell 0.5 per cent to a four-day low of 6992.7.

The worst day for the local share index in the past three weeks came after it hit a two-month high of 7034.3 on Tuesday, just above the 50 per cent retracement of the August 2021 to June 2022 fall.

Canaccord Genuity global equity strategist Tony Dwyer says the two most frequent questions he gets now are: “Is the US economy in recession?” and “Has the market made the low?”

He notes that US rate hikes only began in March and there’s a 6-12 month lag between rate hikes and economic impact, so “it seems unlikely we have felt the full impact of the rate hikes so far off the zero-bound level, much less a move to 3.5 per cent by year-end”.

The Fed doesn’t want to make the mistake it made in the early 1970s, when it reversed its policy tightening at the first sign of an economic slowdown, allowing inflation to become entrenched.

Current market pricing has US rates peaking at 3.6 per cent in 2022, falling to 3.12 per cent in 2023 and 2.35 per cent in 2024, even though the Fed’s latest “dot plot” of interest rate projections from the FOMC has the rate peaking at 3.75 per cent in 2023.

But Dwyer sees still-elevated inflation “forcing the Fed to maintain a hawkish policy stance, even if we have seen peak price pressures”. Following a stronger-than-expected July non-farm payrolls report, the Fed is now widely expected to deliver another outsized rate hike of 75 basis points at its September meeting despite increasing signs elsewhere of slowing growth.

Dwyer also warns that the so-called “neutral rate” of the Fed funds rate is likely to be lower than the Fed expects because of the build-up in debt.

“Fed chair Volker’s forced recession in the early 1980s designed to reverse inflation took place with debt-to-GDP at a generational low point versus today’s historic high,” he says. “Ultimately, economic growth and increased investing come down to money availability for corporations and households. Our favoured gauge of real liquidity – readily available money minus what is being used for economic output – is pointing to a sharp economic slowdown, at best.”

As for the US market, Dwyer says earnings per share assumptions are too high for 2022, and the valuation multiple that the market will put on that is “unclear given the inflation backdrop”.

His view earlier this year that a “transition in monetary policy and economic growth to create a tumultuous first half, followed by a US summer rally, and then a test of the low in (the autumn)” is on track.

The bounce off the mid-June low hit his target, but “the Fed is still raising short-term interest rates into a highly levered system with inventories building and softening demand”.

“We believe the first leg lower this year was the fear of economic weakness given the rapid tightening cycle, and the test of the low may come with the reality of it,” Dwyer says.

“Whether we break from there or not will depend on the Fed. For now, although there could be a bit more upside, we suggest not chasing the market ramp and the more speculative sectors that led it.”