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Dow surged on signs of inflation plateauing and Chinese rollback

calendar 10/08/2022 - 20:09 UTC

On Wednesday, all focus of the market was on the U.S. inflation (CPI) report apart from China-Taiwan/U.S. geopolitical tensions. Wall Street's future got a boost early European session after the Chinese military said the war drill involving Taiwan is almost over:

·         We have completed various tasks around Taiwan

·         We will conduct regularized patrol in the Taiwan strait

·         We will continue to carry out military training to be combat-ready

·         PLA had effectively tested the integrated combat capabilities of the troops

·         Theater forces will keep an eye on the changes in the situation in the Taiwan Strait, continue to carry out training and preparation for combat, organize regular combat readiness patrols in the direction of the Taiwan Strait, and resolutely defend national sovereignty and territorial integrity

Further, Dow Future jumped early U.S. session after July inflation data came cooler than expected, which may keep Fed for a +50 bps hike in September instead the jumbo hike of +75 bps.

On Wednesday, the BLS data shows that the annual inflation (headline CPI) cooled to 8.5% in July from an over 40-year high of 9.1% in June, and below market forecasts of 8.7% (y/y). The July headline CPI was dragged by lower energy costs (32.9% vs 41.6%) amid some cooling in gasoline prices (44% vs 59.9%), fuel oil (75.6% vs 98.5%), and Natural gas (30.5% vs 38.4%), while electricity prices accelerated (15.2%, the most since February 2006). Prices also slowed for new vehicles (10.4% vs 11.4%) and airline fares (27.7% vs 34.1%). On the other hand, the July headline CPI continued to be boosted by food (10.9%, the largest increase since May’1979, vs 10.4%); shelter (5.7% vs 5.6%); and used cars and trucks (6.6% vs 1.7%).

On a sequential (m/m) basis, the headline CPI was almost unchanged (-0.012%) in July against +1.3% in June (a 17-year high) and also below the market consensus of +0.2%. Sequentially, the gasoline index fell 7.7% in July, natural gas declined 3.6%, airline fares slumped 7.8% and prices for used cars and trucks dropped 0.4%. On the other hand, electricity prices went up 1.6%, its third consecutive monthly increase of at least 1.3%; food jumped 1.1%, namely nonalcoholic beverages (2.3%), coffee (3.5%), dairy and related products (1.7%); shelter (0.5%); medical care (0.4%); motor vehicle insurance (1.3%); and new vehicles (0.6%).

The annual core CPI in the U.S. was unchanged at +5.9% in July from the previous month (June) and below market expectations of +6.1% (y/y).

 

On a sequential (m/m) basis, the core CPI increased by +0.3% in July against +0.7% in June, lower than the market expectations of +0.5% and the smallest increase since March.

Overall, till July, the average sequential core CPI rate was around +0.519%; i.e. annualized +6.227%, while the average annual rate was around +6.123%, still substantially above Fed’s +2.00% target. Similarly, the average rate of sequential headline CPI was around +0.873%; i.e. annualized +10.478%, while the average annual rate was around +8.331%, also substantially over pre-COVID levels +2.25% (average).

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The reaction by Fed’s policymakers after July inflation data

On Wednesday, Chicago Fed’s President Evans said:

·         In retrospect, the Fed should have begun raising interest rates six months earlier than it did

·         We may be able to tighten monetary policy enough to bring inflation down while keeping unemployment near 4.25%

·         Geopolitical uncertainties throughout the world are also a source of concern

·         Other dangers to economic development include Russia's invasion of Ukraine

·         We'll be dealing with supply chain challenges for a lot longer than I'd prefer

·         I foresee 1.5% to 2% growth next year

·         The economy is probably certainly a little more fragile, but it would take something negative to cause a recession

·         I don't expect the economy to slow significantly anytime soon

·         Today's inflation report is the first positive report

·         I'm positive forecasting that next year Core PCE inflation will be nearer to 2.5%

·         I expect rates to rise this year and next

·         Today's inflation report is the first good report

·         The economy will continue to grow in the 2H

·         Strong employment is a reflection of a still-strong economy

·         The US jobs market is vibrant

·         Inflation is still "unacceptably" high, and the Fed will likely need to lift its policy rate, currently in the 2.25%-2.5% range, to 3.25%-3.5% this year and to 3.75%-4% by the end of next year

·         I feel like we're in a good place and we can pivot to be more restrictive if inflation gets out of hand more than what I'm thinking about

·         But also, if things get better more quickly, we cannot raise rates quite as much as I've just indicated

·         I think we're well-positioned now for a couple of different turns of the data over the next few months

·         I do not think the recent jobs report necessarily pointed to more inflation, but we need more data on that

·         We’ve tightened monetary policy quite a lot, very quickly---

On Wednesday, Minneapolis Fed President Kashkari said:

·         We may enter into a recession shortly

·         Realistically, rates will be raised and held until inflation reaches 2%

·         The idea of cutting interest rates early next year is unrealistic

·         I am happy to see inflation surprised to the downside

·         But we are far far far away from declaring victory on inflation

·         This does not change my rate hike forecast, which is for 3.9% this year and 4.4% next year

·         Realistically, rates will be raised and held until inflation reaches 2%.

Conclusion:

On Wednesday, Fed’s ‘unofficial’ mouthpiece WSJ said the Fed is likely to want further evidence of inflation slowdown. Fed goes by core PCE inflation for its price stability mandate and rate setting. If the sequential core PCE inflation is also around +0.2% in July (in line with the core CPI rate), the annual reading would be around +4.66%, almost unchanged from June. Fed needs the sequential rate to be around +0.2% on a sustainable basis, so that core PCE inflation falls at the target of +2.00%.

The July pause in inflation reading is entirely due to lower prices of oil, which may recover in the coming days, especially in the winter; core inflation is still quite sticky and Fed may not change its decision on one month’s report. Fed will observe the August reading of inflation and inflation expectations along with the job report and will hike either by +0.50% or by +0.75% in September. If actual inflation data also comes cooler in August, Fed may go for a +0.50% rate hike in September instead of +0.75%, which will boost Wall Street ahead of the Nov’22 mid-term election. Taiwan issue is a domestic political compulsion for both China and U.S. After Nov’22 mid-term election, Biden may take necessary steps to restore the broken relationship with both Xi (China) and Putin (Russia) to restore the broken supply chain and cooling of inflation.

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