US CPI data pushes Fed rate hike odds higher; Wall Street bounces back

The North American trading day saw multiple competing forces on Friday. Inflation remained elevated in the US, consumer morale deteriorated, Treasury rates mostly climbed, and geopolitical risks in the Middle East kept energy supply concerns alive. Nonetheless, US equity markets broke a four-session losing streak, aided by a notable drop in crude oil prices.

US inflation keeps the Fed on alert

The August Consumer Price Index rose 0.4% compared to the prior month, picking up from the 0.1% gain recorded in July. The annual headline inflation rate held steady at 3.4%.

The core reading, stripping out food and energy items, advanced 0.3% on a monthly basis and stood 2.4% higher than a year earlier. Gasoline prices climbed 3.9% in August and contributed more than one-third of the monthly headline rise.

The release was far from a disaster for inflation, but it was also not mild enough to rule out further policy tightening. By the close of trading, Fed funds futures priced in close to a 90% chance of a quarter-point interest rate increase from the Federal Reserve next week. With expectations that elevated, the Fed would risk damaging its credibility further if it opted to stay idle. The Warsh Fed Era will start with a hike.

Michigan sentiment adds to the inflation concerns

The preliminary University of Michigan Consumer Sentiment Index dropped sharply to 47.8 in September, falling from 51.7 in August and missing the consensus estimate near the halfway mark.

Equally relevant was the inflation-expectations component:

• One-year inflation expectations rose to 4.6% from 4.0%
• Five-year inflation expectations edged up to 3.4% from 3.3%

Higher fuel prices, trade tensions and worry about personal finances are squeezing consumers. For the central bank, increasing inflation expectations matter because such expectations can eventually influence wage demands and pricing behavior. With labor markets tight due to immigration changes and data center build demands, the risk can be real. It's not a great time to be in a prolonged war, but that is where the US is at.

Treasury yields rise, but the curve flattens

Treasury yields along the shorter end reacted most strongly to the higher probability of a Fed hike, while the 30-year yield barely changed:

• 2-year yield: 4.6450%, +7.8 basis points
• 5-year yield: 4.5620%, +5.1 basis points
• 10-year yield: 4.4820%, +2.7 basis points
• 30-year yield: 4.3420%, -0.3 basis points

The more noticeable rise in the two-year yield captures the higher odds of tighter Fed policy. The long end of the curve was more restrained, causing a flattening in the yield curve.

For the week:

• 2-year yield: +25.1 basis points
• 5-year yield: +23.6 basis points
• 10-year yield: +18.3 basis points
• 30-year yield: +10.9 basis points

US stocks rebound despite higher yields

Equities in the US pushed higher after four consecutive sessions of losses. The sharp retreat in oil helped relax some inflation apprehension, and gains in technology stocks provided extra support.

• Dow Jones Industrial Average rose 0.98% to 52,573.29
• S&P 500 rose 0.86% to 7,656.98
• Nasdaq Composite rose 0.96% to 26,333.04
• Russell 2000 rose 0.40% to 2,903.94

For the week:

• Dow Jones Industrial Average: -1.57%
• S&P 500: -0.80%
• Nasdaq Composite: -0.66%
• Russell 2000: -2.41%
• Nasdaq 100: -0.59%

The bounce recovered some of the week's losses, but all the leading benchmarks still ended the week in negative territory.

Foreign currencies versus the US dollar

The greenback ended mixed versus the main counterparts. Expressed as the performance of each foreign currency against the dollar:

• Japanese yen: +0.48%
• New Zealand dollar: +0.24%
• Australian dollar: +0.20%
• British pound: +0.10%
• Euro: -0.02%
• Canadian dollar: -0.26%
• Swiss franc: -0.50%

The JPY printed the strongest performance, while the CHF was the weakest against the dollar.

For the week:

• Japanese yen: +1.7%
• New Zealand dollar: -1.14%
• Australian dollar: -0.47%
• British pound: +0.09%
• Euro: -0.13%
• Canadian dollar: -0.27%
• Swiss franc: -0.78%

Middle East tensions remain elevated

Geopolitical risks in the Middle East continued to pose threats to global energy supplies. According to reports, projectiles hit Saudi Arabia’s East-West oil pipeline system, and Houthi forces kept up their advance along Yemen’s Red Sea coast.

The International Energy Agency estimated that crude output from Saudi Arabia fell to about 6 million barrels per day in August, the lowest level in more than three decades, after attacks on energy infrastructure and shipping routes.

Notwithstanding these risks, oil prices moved sharply lower on Friday. West Texas Intermediate crude dropped -$2.43 or -2.37% to $100.05. Over the trading week, price rose by $8.54, or 9.35%.

That price movement offers an important trading lesson. Good news does not inevitably translate to higher prices. If a market fails to rise on supportive headlines, it may suggest the news has already been incorporated or buyers are getting depleted. Nonetheless, oil remained significantly higher for the week, and geopolitical risks remain unresolved.

Other commodity moves:

• Gold rose 0.66% to $4,349.44. For the week, the price was down -$80 or -1.81%
• Silver rose 1.23% to $64.41. For the week, the price was lower -$1.71 or -2.58%
• Copper was essentially flat at $6.5435. For the week, the price fell -$0.12 or -1.90%

Looking ahead to next week

With the CPI and PPI releases now behind us, what key events will dominate the coming days?

The event will be highlighted by three major central bank decisions:

First, the Federal Reserve announces its policy decision on Wednesday. Following the stronger CPI report, markets are pricing nearly a 90% probability of a quarter-point rate increase. The new economic projections, dot plot and Kevin Warsh’s press conference will be just as important as the rate decision itself. We know Fed Chair Warsh does not like things like the dot-plot, but the market does. Will that be resolved?

Second, the Bank of England meets on Thursday. The BOE is predicted to keep its Bank Rate unchanged at 3.75%, but the vote split and policy guidance will be under scrutiny—particularly after Wednesday’s UK inflation report.

Third, the Bank of Japan decision is another potential source of volatility. Markets will watch if the BOJ raises its policy rate toward 1.25%. Any surprise, or shift in guidance, might generate a significant move in the yen.

Key events by day:

• Monday, September 14: Canada CPI, including headline CPI, median CPI and trimmed-mean CPI. Headline CPI is expected to decline 0.1% month-over-month, following a 0.5% increase previously.
• Tuesday, September 15: UK employment report, including claimant count change. Claims are expected to rise by 8,300, after an 11,000 decline previously.
• Wednesday, September 16: UK CPI is expected to rise to 3.1% year-over-year from 2.9%. The Federal Reserve announces its rate decision at 2:00 PM ET, followed by its statement, updated economic projections, and dot plot. Jerome Powell’s press conference begins at 2:30 PM ET. New Zealand GDP is released later, with growth expected at 0.1% quarter-over-quarter, down from 0.8% previously.
• Thursday, September 17: The Bank of England releases its rate decision, vote split, and Monetary Policy Summary. The Bank Rate is expected to remain unchanged at 3.75%. The Bank of Japan also announces its policy decision, timing listed as tentative.
• Friday, September 18: The Bank of Japan holds its post-meeting press conference, timing also tentative.

With decisions from the Fed, BOE and BOJ, plus inflation reports from Canada and the UK, next week looks set to be another volatile period for currencies, bonds, and equities.