Wall Street tumbled on hotter CPI and higher bond yields

On Wednesday, Wall Street Futures surged on less hawkish FOMC minutes and Fed talks, indicating a high probable Fed pause on 1st November amid simmering Middle East geopolitical tensions, Chinese slowdown, and surging borrowing costs for the U.S. government. But irrespective of whether another +25 bps rate hike or not, the Fed is now clearly emphasizing on ‘higher for longer’ policy. Fed may go for a hawkish hold policy action/stance as the Fed may continue to project at least another hike in December and one hike in H1CY24 (March/June) to continue its hawkish hold stance and to ensure tighter financial conditions and also Fed credibility. The Fed is now preparing the market for higher for longer policy and another hike in December (if required)- then a possible end of the tightening cycle by Dec’23. Overall, the U.S. labor market and core inflation trajectory are still hot enough for another Fed hike.

On Thursday, all focus of the market was on U.S. core CPI inflation for September as it may influence the Fed for any rate action/stance on 1st November. Although the market is already discounting a pause on 1st November, but Fed may still indicate another +25 bps rate hike on 13th December, which should be the final for the current rate hiking cycle.

On Thursday, the BLS data showed the annual US core inflation (seasonally not adjusted core CPI) further eased to +4.1% in September from +4.3% sequentially, in line with the market consensus of +4.1% and the lowest since Sep’21. In Sep’22, the annual core CPI was +6.6%, and +5.6% in Jan’23; i.e., the core CPI has reduced by almost -2.50% in the last 12 months, which is almost -0.20% per month on an average. At this run rate, core CPI should be around +3.5% by Dec’23, +3.0% by Dec’24, and +2.0% by Dec’25 - at target in line with the Fed’s estimate of Dec’25 (after considering some volatility due to elevated oil prices).

In Sep’23, core CPI was boosted by the shelter index (accounting for over 70% of the total increase), which rose 7.2% in September, although eased from August's 7.3%. Prices also slowed down for new vehicles (2.5% vs 2.9%); apparel (2.3% vs 3.1%) and transportation services (9.1% vs 10.3%). Moreover, another steep decrease was seen for used cars and trucks (-8% vs -6.6%).  A slump in airline fares dragged the core CPI

The U.S. Core service inflation (w/o energy service) also eased to +5.7% in September from +5.9% sequentially and Jan’23 reading of +7.2%, it’s still substantially above pre-COVID average levels of 2.8%. Fed is now closely focusing on core service inflation, which is still quite elevated and sticky.

On Wednesday, the BLS data showed the sequential (m/m) US core CPI (seasonally adjusted) rose +0.3% in September from +0.3% in August, in line with market expectations of +0.3% advance. In Sep’23, the sequential core CPI was boosted by higher costs for services unrelated to energy (0.6% vs 0.4% in August), higher prices for shelter (0.6% vs 0.3%), and medical care (0.3% vs 0.1%). In the meantime, the CPI increased at a steady pace for new vehicles (0.3%) and at a slower pace for medical care services (0.7% vs 2%). On the other hand, consumer prices fell considerably for used cars and trucks (-2.5% vs -2.1%) and apparel (-0.8% vs 0.2%).

Fed needs +0.2% sequential core CPI consistently for its annual core CPI target of +2.0% on a sustainable basis. Overall, the 3M rolling average of underlying core CPI may be now running around +4.3% and if September core PCE inflation comes around +3.7% (sequential rate +0.3% - in line with core CPI), the average core inflation (CPI+PCE) would be around +4.0% in Sep’23.

On Wednesday, the BLS data also showed annual (y/y) total/headline CPI rose by +3.7% in Sep’23 from +3.7% sequentially, above the market expectations of +3.6%. In Aug’22, the annual CPI was +8.2% due to higher oil & food prices. Oil prices have been on the rise in the previous two months, which coupled with base effects from last year, pushed the inflation higher.

In Sep’23, energy costs fell by 0.5%, following a 3.6% decrease in August, primarily driven by a rebound in fuel prices. Additionally, prices increased at softer rates for food (3.7% vs. 4.3%), new vehicles (2.5% vs. 2.9%), apparel (2.3% vs. 3.1%), medical care commodities (4.2% vs. 4.5%), shelter (7.2% vs. 7.3%), and transportation services (9.1% vs. 10.3%). Costs for used cars and trucks, as well as medical care services, continued to decline.

On a sequential (m/m) basis, the headline CPI (seasonally adjusted) eased to +0.4% in September from +0.6% in August, but above the market consensus of +0.3%. In Sep’23, shelter prices rose 0.6% (vs 0.3% in August), accounting for over half of the sequential CPI increase. An increase in the gasoline price was also a major contributor to the all items monthly rise (2.1% vs 10.6%). While the major energy component indexes were mixed in September, the energy index rose 1.5% over the month. The food cost increased 0.2%, as it did in the previous two months. The index for food at home increased 0.1% over the month while the index for food away from home rose 0.4%.

The 3M rolling average of underlying total CPI may now be running around +4.0% against core CPI of +4.3%.

The market is now concerned about still elevated and sticky shelter inflation, which rose for the 41st consecutive month sequentially.

 

The average sequential rate for U.S. core CPI (seasonally unadjusted) was around +0.11% in 2020, +0.45% in 2021-22, and estimated +0.35% in 2023. At a current average sequential rate of +0.25% in the last few months, the annual core CPI should be around +4.3% in Dec’23 against +5.7% in Dec’22. Looking ahead, if the rate of average sequential core CPI further declines to around +0.25% in 2024 and +0.15% in 2025, then the annual core CPI would be around +3.0% by Dec’24 and +2.0% by Dec’25-in line with Fed’s present projections. Thus there is a need for a higher restrictive rate for longer policy at least till Sep’24. By Sep’24, U.S. core CPI should be around +3.0% and then the Fed may go for rate cuts of at least -50 bps a quarter. Fed may not hike further in Nov/Dec’23, keeping terminal repo rate at +5.50% with a hawkish hold stance at least till Q1CY24/H1CY24.

Conclusion:

Fed may go for a hawkish hold policy action/stance on 1st November amid excuses of Israel-Hamas war/simmering ME geological tensions and rising 10Y US bond yield. But the Fed may continue to project at least another hike in December and one hike in H1CY24 (March/June) to continue its hawkish hold stance and to ensure tighter financial conditions and also Fed credibility.

The Fed is now preparing the market for higher for longer policy and another hike in December (if required)- then a possible end of the tightening cycle by Dec’23.

As per Taylor’s rule, for the US:

Recommended policy repo rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(5.50.00-2.00) =0+2+3.50=5.50%

Here:

A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= average core inflation (CPI+PCE) =5.50% (for 2022); H1CY23 average core inflation around +5.40% (~5.50%)

If the Fed pauses in Nov/Dec’23 and keeps the terminal repo rate at +5.50% against the average projected core CPI for 2023 around +4.9% (~5.0%), then BOE may not also hike further, but ECB may have to hike by another +50 bps for a terminal repo rate at +5.25% to keep policy parity with Fed and control imported inflation. ECB is far behind the curve and wasted the first 4-months of 2022 by not hiking in line with the Fed.

Looking ahead, the Fed may try to balance the financial/Wall Street stability and price stability by expressing intentions to cut from June’24 (H2CY24) to ensure a soft landing while bringing down inflation. Also, the Fed has to ensure lower borrowing costs for the U.S. Government (Treasury) endless deficit spending and mammoth public debt of almost $32T. The U.S. is now paying around 9.5% of its revenue as interest on public debt against China/EU’s 5.5%. This is a red flag, and thus Fed has to operate in a balancing way while going for calibrated hiking to bring inflation down to target, avoiding an all-out recession; i.e. to ensure both price stability and soft-landing.

Overall, it seems that the White House would be quite happy if the Fed could bring back core inflation towards 2% on a durable basis, while keeping the unemployment rate below 4% ahead of Nov’24, the U.S. Presidential election. The Fed is itself eager to cut its losses by cutting rates. The U.S. 2Y bond yield is now hovering around +5.15% and may soon scale 5.25-5.50% in hopes of another +25 bps Fed rate hike for a terminal repo rate of +5.75% by Nov’23. Even after the expected pause after Nov’23, the Fed may keep open for further hikes by projecting at least another 25/50 bps hike in H1CY24 (one rate hike at Q1 and Q2) if core inflation does not fall as expected as a result of the still hot labor market and other demand-related factors.

Market wrap:

On Thursday, Wall Street Futures were dragged by hotter-than-expected headline inflation (CPI) and core service inflation. The market is now concerned about a ‘higher for longer’ policy stance, which may adversely affect discretionary private as well as government spending and eventually corporate earnings. Dow Future stumbled from around 34150 to almost 33600, but recovered in late-day trading (after short covering) as the overall trend of core inflation may indicate a Fed pause/pivot; the Fed may not hike further unless there is an unusual spike in core CPI. On Thursday, Wall Street Futures, and Gold were also dragged by higher bond yields on weak demand for U.S. debt; USD surged.

On Thursday, Wall Street was dragged by materials, utilities, real estate, consumer staples, communication services, consumer discretionary, healthcare, industrials, and financials, while dragged by energy and techs to some extent. Oil stumbled on unexpected inventory addition by both API and EIA surveys and the concern of subdued demand in 2024 (as projected by EIA). Dow Jones was dragged by Boeing, McDonald’s, Verizon, IBM, Caterpillar and JPM, while boosted by Walgreens Boots, Nike, Apple, Amgen, Visa, Walmart, and United Health.

Bottom line:

Fed may continue the hawkish hold stance not only in Nov/Dec’23 but till at least Q1/H1CY24.

Technical trading levels: DJ-30, NQ-100 Future, Gold and oil

Whatever may be the narrative, technically Dow Future (33900) now has to sustain above 34200 levels for a further rally 34350/34450-34555/34650 and further to 34825-35070/200-415/850 levels; otherwise, sustaining below 34150-33900 may again fall to 33600/33450-33200-32950 and further to 31700-31500 levels in the coming days

Similarly, NQ-100 Future (15350) now has to sustain over 15500 levels for a further rally to 15750/900-16000/655 in the coming days; otherwise, sustaining below 15450-400, may again fall to 15000-14700, and further to 14500-14300/175-100/13890 and 13650-13125 levels.

Gold (XAU/USD: 1880) now has to sustain above 1890 for any further rally to 1900 and 1910/1920-1926/1937 and 1952/1970 levels; otherwise, sustaining below 1885/80, may again fall to 1870/60-50/40 and 1825/1810-1798*/1770 level in the coming days.