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After months of being mauled by hot US Consumer Price Index reports, markets breathed a collective sigh of relief on Thursday as one finally came in below consensus.
Both the headline (7.7%) and core (6.3%) inflation figures for October came markedly below expectations, and the details within the report were also encouraging. Core goods prices were down and services inflation decelerated, including the more sticky Shelter and Owner’s Equivalent Rent sub-components. Markets reacted as one would expect, with gains across the board in government bonds, equities and spreads, while the dollar depreciated against most currencies as markets trimmed future hikes from the curve. While slightly overshadowed by the CPI news, we also saw marginal increases in both Initial Jobless Claims and Continuing Claims, which can be viewed as a positive given the Fed’s focus on loosening the labour market as part of its battle with inflation.
Clearly one data point does not make a trend, but it is also true that all trends start with one data point, and a cooling inflation trend is what markets are increasingly pricing in. In summary, the source of the chaotic market action in 2022 has been central banks responding to stickier inflation by raising rates much faster and to a significantly higher level than expected only at the beginning of the year. This was rapidly reflected in soaring yields across government bond curves, causing a marked tightening of financial conditions, and prompting recession fears which were reflected in wider spreads and lower equity prices. Markets dislike uncertainty, and so volatility was never likely to fade until investors thought they had more clarity around direction of travel in CPI, and thus more clarity around when the Fed and other central banks might pause their hiking cycles.
It follows that once the source of the problem, i.e. inflation, shows signs of improvement, this will allow central banks to reach their terminal rates for the cycle and pause. Less uncertainty about where rates might peak should translate into less volatility across government bond curves, which should in turn bring about a reduction in risk premiums globally. Combined with the highest yields we have seen in years and a healthy amount of cash sitting on the fence waiting to be invested , this could well mean financial markets finally enjoy a more tranquil period and investors can start to see decent returns again.
That said, we should not downplay the risks. For starters we need confirmation that this data point starts to look more like a trend in the coming weeks and months. There are some elements of inflation that seem to have peaked globally, including in the US, but the trends are not clear yet. Then markets will need to assess how quickly inflation is coming down, which will of course determine when central banks will actually reach their terminal rates for this cycle, and how quickly after that they may be able to start cutting rates. For that, we need to closely watch the labour market for signs of weakness. In addition, it is almost a certainty that Fed officials will try to foster these nascent downward inflation tendencies by maintaining their hawkish stance and preventing financial conditions from loosening too much. Finally, it remains to be seen how severe the impact on growth will ultimately be. Financial conditions have tightened very rapidly and the economy is going to suffer.
Nevertheless, while the battle against inflation is far from over, Thursday’s CPI data was a big step in the right direction. Inflation is the root cause of many of the headwinds markets are currently facing, and it therefore makes sense to think that once the issue improves, so will market sentiment. If we add to the mix that there is a healthy amount of cash on the side-lines and that the cost of being out of the market hasn’t been this high for a long time (due to the elevated yields on offer), in addition to the positive quarantine news out of China, the result may be a more stable period for financial assets.