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Inflation Jitters and Rate Cut Riddles

Investors are on the edge of their seats, waiting for the latest scoop on US inflation data to take a fresh direction in both stock and bond markets. The dollar index remains offered, the US political risks are casting shadows, and there’s a rising chorus of opinions playing the guessing game on when and how much the Fed might trim the rates next year.

The S&P500 consolidated on Monday after a 7.5% rally since end of October, while Nasdaq 100 eased 0.30% following an almost 10% rally. The US 10-year yield steadied a touch above the 4.60% level.

According to the consensus of analysts on a Bloomberg survey, the US inflation may have slowed to 3.3% last month, from 3.7% printed a month earlier. Core inflation is seen unchanged at 4.1%. The waning supply chain disruptions, the loosening US jobs market, a further fall in gasoline prices and the expectation of a decline in rents are among the major factors that could help inflation ease – after a more than 1.5-year aggressive policy tightening from the Fed of course.

But not all indicators are in green. An uptick in health insurance costs could give a slight boost to October inflation figures, while the latest US consumer survey, released last Friday, showed that the US consumers expect inflation to climb at an annual rate of 3.2% over the next 5 to 10 years. In contrast, economists see inflation fall to 2.5% in the next five years and down to 2.2% in the next 5 to 10 years, and the bond prices imply a CPI of 2.36% in the period of 5 to 10 years from now.

For today, an inflation read in line with expectations, or ideally softer than expected, should give further support to the Federal Reserve (Fed) doves, cement the idea that the Fed is done hiking the interest rates and boost the rate cut expectations for next year. A read above expectations should bring Fed hawks back to the market and increase the bets of a rate hike in December. But activity on Fed funds futures gives around 85% chance for a no rate hike in the Fed’s December meeting, and the inflation numbers must look very bad to reverse that expectation.

And anyway, what investors are interested in right now is not whether the Fed will hike one more time or not – because they are convinced that it won’t. Instead, what everyone is trying to figure out right now is: when will the Fed start cutting rates, and by how much will it cut rates next year. Goldman Sachs doesn’t expect a rate cut from the Fed until this time next year. Morgan forecasts two deep rate cuts next year starting from June, and UBS’ Investment Bank anticipates the first rate cut as early as in March and a 275bp cut in 2024.

If inflation continues to ease and the US jobs market and the economy starts slowing – which is our base case scenario for the next 12 months – the Fed should start lowering rates. But given how reactive the Fed has been to mounting inflation, the rate cuts shouldn’t start before September, but when they start the loosening should be rapid.

Ceteris paribus, the US 2-year yield should hover around the 5% mark, the 10-year yield will remain appetizing approaching the 5% mark – and could hardly go above this level unless there is an economic shock, or a political turmoil, and a potential rating downgrade.

The US dollar index remains offered at the 50-DMA and could further extend losses with the sight of a sufficiently soft inflation report, while the USDJPY was sold near the 152 level. There are different rumours regarding the nature of the sudden jump in the yen on Monday. It could be a direct FX intervention, or it could be the result of options positioning. But in both cases, selling the yen at the current levels means taking the risk of a sudden reversal, either because of a broadly softer US dollar, or because of a direct intervention.

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