Inflation Readings Complicate Rate Cut Timing For Markets

Stocks and bonds fell during the week as hostile inflation readings increased economic uncertainty. The most economically sensitive parts of the stock market, such as small-cap Russell 2000 stocks, and interest rate-sensitive sectors, such as banks and real estate, were hardest hit.

The 10-year and 2-year US Treasury yields rose sharply to 4.3% and 4.7%, respectively. The rapid rise in yields caused the Bloomberg US Aggregate Bond Index to fall 1.2% for the week.

Consumer inflation (CPI) was higher than expected last week at a year-on-year rate of 3.2%. Perhaps most importantly, services inflation remains high and sticky. The supercore measure of utility inflation, which removes distortion from the government's exaggerated measure of rent inflation, was stable at 4.3% year over year.

Adding to concerns about inflation were producer prices (PPI), which were also higher than expected last week. While the absolute level of 1.6% year-on-year would not normally raise eyebrows, much of the improvement in consumer inflation is due to goods and energy disinflation. Therefore, a reversal of the trend in producer prices could be the prelude to upward pressure on the CPI.

The Cleveland Fed's March consumer inflation estimate rose to 3.3% year over year last week.

While monthly recent Job reports have been noisy with weak spots beneath the surface., the most common measures of labor market health do not indicate any significant deterioration. Wage pressures are likely to keep services inflation elevated if the labor market remains resilient.

Reacting to the higher inflation readings, markets have now priced in a 60% chance of a Fed rate cut in June, up from nearly 100% the week before. The odds now favor a June or July start of short-term interest rate cuts by the Federal Reserve. Fed funds futures expect three 25 basis point (0.25%) cuts in 2024, up from four the previous week.

The Federal Reserve meets on Wednesday with virtually no change in monetary policy. While the outcome of the Fed meeting will contain no surprises, Fed Chair Powell's comments will be scrutinized for clues about how critically he views the recent inflation data. This meeting also includes Fed forecasts and the dot plot to add evidence to predict the timing of future monetary policy actions. Given the strong reaction in bond yields last week, interest rate-sensitive bonds and stocks could be particularly volatile towards the end of Wednesday's Fed meeting.