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Sticky Inflation Challenges Rate Cut Expectations

The month of May witnessed yet another recalibration of market participants’ expectations in a year where frequently changing narratives have dominated the price action thus far. Stripping away the impact of mega-caps in the S&P 500 Index, where the frenzy for artificial intelligence has pushed valuations to dizzying heights, the broader US equity market is in fact in red during the first five months of 2023 (See Figure 1). In our view, the year-to-date price action of the broader market reflects abundance of caution, given frequent and abrupt shifting of expectations around inflation and central banks’ interest rate policy.

Figure 1: Broader US equity market has traded cautiously.

Broader US equity market has traded cautiously
Source: Bloomberg

Since the hint of a pause by the US Fed chairman last month, the US Personal Consumption Expenditure Core Price Index (PCE), the Fed's preferred measure of inflation, came in at +4.7%, ahead of expected and last months reading of +4.6%. Earlier, the headline inflation in Canada came in at +4.4%, much ahead of expected +4.1% and last month’s reading of +4.3%. The readings for the ISM Manufacturing and Services PMI (Purchasing Managers’ Index), leading indicators of future manufacturing and services sector activity, also advanced from previous months and unemployment in the US dropped to +3.4% for April (reported in May). In Canada, higher-than-expected inflation and stronger-than-expected GDP growth also brought back expectations of rate hikes restarting. These macroeconomic datapoints have corroborated to suggest that the economy is chugging along just fine and perhaps expectations of a rate pause and/or a cut are premature. The economic data supporting a hawkish stance of central banks and escalating risk of a US default as the debate around raising the US debt ceiling approached deadline amidst political brinkmanship, had created a perfect storm for the broader markets in May.

The past few days brought respite to the wary markets after comments from a few Fed officials indicated that the Fed might be willing to pause the interest rate hikes and wait and watch the macroeconomic data evolve for some time. This was upended by the Bank of Canada, which raised policy rates by 25 basis points to +4.75% citing persistent excess demand in economy. Nevertheless, we note that ISM Manufacturing and Services PMI data for May (reported early June) showed signs of cooling off, and US unemployment rose to +3.7%. As per CME Group’s data, the target rate probability for a 25 basis-point hike during the June Federal Open Market Committee meeting increased from +8.5% as on May 5th to +64.3% as on May 26th and had dropped to +25.3% as on June 2nd. More importantly, the probability of no rate cut by the end of the year increased from +0.1% as on May 5th to +36.1% as on June 2nd, indicating market participants are warming up to the message that the expectations of rate cuts during this year are unwarranted as inflation remains too high and the economy is resilient enough to withstand the rate hikes.

The price action during the last month validates our stance that near-term caution is warranted, given choppiness of the incoming economic data put together with differences in central banks’ outlook and baked-in expectations of equity and debt market participants. In our view, diminishing friction between market participants’ expectations of rate cuts and central banks’ guidance is a constructive set up for risk assets. We think the broader markets could start to climb the wall of worry during the second half of the year if central banks display restraint while inflation cools off in fits and starts and the economy keeps chugging along.

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