Chances of three rate cuts this year in the US diminish

The US consumer price index (CPI) surprised on the upside for the third consecutive month. Most sub-categories and sub-aggregates registered worse than expected figures. On a month-on-month basis, both headline and core inflation, which excludes food and energy costs, came in at 0.4%, pushing short-term trends away from the CPI's path towards the Federal Reserve's (Fed's) 2% target. The only consolation prize was a negative core goods inflation figure which gives some hope that perhaps goods disinflation is not quite over.

Core services inflation remained at 0.5%, unchanged from February. Although inflation in this very important component is notably lower than the highs, the advance appears to have stalled at levels above those consistent with the Fed's inflation target. Unlike the previous labour market report, we think that this CPI data does change the outlook for the Fed. Chairman Powell mentioned that they needed to be more confident that inflation was indeed moving in the right direction for rate cuts to become a reality. Given that this is the third consecutive reading that has surprised to the upside and that the services price index in particular refuses to come down, we cannot help but think that the chances of three rate cuts this year in the US have diminished.

This does not mean that inflation targets will not be met or that we are now in an environment of permanently higher inflation. Time will tell and there is a lot of uncertainty in economic forecasts at the moment, but we think it is unlikely that there will be a major inflationary shock or that the upward trend will be renewed. We would therefore characterise the current dynamics as a delay in inflation approaching the target, rather than a complete abandonment of the more protracted downtrend that began in July 2022. Although the US has shown resilience, there are signs of stress in certain parts of the economy, such as data on auto loans and credit card delinquencies. Growth is expected to slow as the year progresses, which should also help manage inflationary pressures.

Market reaction was swift, with US Treasuries giving up close to 20 basis points at the short end and just over 10 basis points at the long end, as the market discounts short-term rate cuts. European spreads held up reasonably well, while US spreads suffered more, with high yield and investment grade spreads widening by 16 basis points and 3 basis points respectively at the index level. It is possible that markets will suffer a slight decline due to the prospect of rate cuts, but ultimately, if as we believe it is only a delay, we would bet that the market will take advantage of a sell-off as a buying opportunity, thus limiting the extent of the massive spread sell-off. However, it is important to remain vigilant. In our view, the probability of a hard landing would start to increase if inflation developments prevent the Fed from cutting rates. It would be more likely that something would break somewhere in the economy. To be clear, we don't think we are at that point at the moment, but it is certainly worth remaining flexible and having liquidity to react to a change in the baseline scenario.