Inflation data holds a surprise party for markets

• The latest U.S. Consumer Price Index (CPI) data indicated a likely end to the Fed's rate hikes, and the market responded with a rally in stocks and bonds.
• The U.S. Producer Price Index for October showed a surprising decrease, signalling a broader easing of inflationary pressures across various sectors.
• U.S. retail sales in October were better than expected, but major retailers like Walmart reported weakening consumer spending, indicating a mixed outlook for the retail sector.

We have consistently maintained that July’s interest rate hike would likely be the U.S. Federal Reserve's (the Fed) last for this cycle, and the latest Consumer Price Index (CPI) data from the U.S. strongly supports this view. The CPI missed expectations across all categories, notably propped up only by shelter inflation, which is typically delayed by 12 months and expected to normalize. In response, we saw a significant rally in stocks and Treasuries, while the U.S. dollar experienced a sharp decline. Interestingly, that decline held on throughout the week against most world currencies except a notable one: the Canadian dollar.

Particularly notable was the performance of the small-cap Russell 2000 Index, which saw gains surpassing 5%, a clear indication of renewed interest in previously overlooked sectors. This response in the markets, though somewhat outsized for a mere 0.1 percentage point surprise in CPI, aligns with our expectations of an accommodative shift in the Fed's interest rate path.

The U.S. Treasury yield curve reacted with its largest one-day fall since the March banking crisis, a clear sign of changing market sentiment. The money markets have now recalibrated their expectations, eliminating the risk of a December rate hike and pricing in cuts totaling 100 basis points in 2024, up from the previously anticipated 75 basis points. This forward-looking adjustment suggests a potential rate cut as early as March 2024, fitting with historical patterns of Fed interest rate adjustments. Historically, there are on average eight months between the last interest rate hike and the first cut.

The U.S. headline Producer Price Index (PPI) for October brought another surprise when it decreased by 0.5% month-over-month, compared to an expected rise of 0.1%. Year over year, the increase was only 1.3%, significantly lower than the anticipated 1.9%. This decline was largely driven by a decrease in energy prices while food prices remained stable. Core PPI figures also showed a slowdown, indicating a broader easing of inflationary pressures. This data suggests a potential moderation in the October core Personal Consumption Expenditures (PCE) deflator, a key indicator watched by the Fed.

October's retail sales in the U.S. showed resilience, declining by just 0.1% compared to its forecast drop of 0.3%. However, caution is warranted, as major retailers like Walmart have signalled a weakening in consumer spending. Target's CEO's remarks about the decline in unit demand and discretionary spending underscored this cautious outlook.

Industrial production and retail sales out of China exceeded expectations, boosting the Chinese stock market. However, this optimism was somewhat tempered by Alibaba's announcement of cancelling its cloud unit spin-off.

Listen to this week’s podcast for further insights.