Goldilocks beware: US inflation data puts markets on notice

The latest US CPI data surprised to the upside. Pendal’s head of government bond strategies, TIM HEXT, explains what it means for investors

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THE inflation numbers were released this week and surprised to the upside.

Headline for January was up 0.3% (3.1% year over year) and core up 0.4% (3.9% year over year).

This meant that CPI has, for now, failed to follow the PCE (the Fed’s preferred inflation measure) below 3%.

This was only a small miss, 0.1% higher than expected, but was still against the narrative of falling inflation.

After all, the US needs monthly inflation numbers hitting 0.2% before the Fed can relax.

In the US, CPI is heavily influenced by what is called Owner’s Equivalent Rent.

Unlike most countries which only measure rents for those actually renting (in Australia this is 6% of the CPI), the US CPI tries to capture the idea that owners are ‘consuming’ their residence by putting an equivalent rent on it.

This is almost 25% of the CPI basket, on top of the 7.5% for actual rent. Together, they make up housing inflation.

Analysts use Zillow private sector rent numbers as a good lead indicator, but the downward trend there was not matched in this CPI.

Maybe next time.

There was other noise in the numbers, but the market was focused on core services.

The narrative of core goods falling (down 0.3% in this number) contrasts with core services (ex-shelter), which were up 0.7% on the month.

It’s hardly time for the Fed to declare victory.

The focus will now turn to whether core PCE can stay down around 2% annualised or drift higher towards CPI at 3%.

The PCE has a smaller weight to shelter of only 15%. This will help keep it lower than CPI for now.

Historically, core CPI has been around 0.3-0.5% above core PCE as housing has increased at a faster pace than other services.

The following graph, courtesy of Citigroup, shows that these gaps between CPI and PCE do open up quite often, especially when house prices are on the move.

Source: Citigroup, 2024

For now, the markets will grant inflation a bit of leeway.

Yes, cuts from The Fed are being pushed out and bond yields are drifting higher.

Inflation break-evens (long-term expectations) only moved 0.05% higher (from 2.25% to 2.3% for 10 years).

But the market is on notice.

If this becomes a trend in the months ahead, then risk markets will start to take notice, as rates will stay higher for longer and the chances of a recession also increase.

Goldilocks beware.

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Our view is that the overall trend to lower inflation is still intact, but the sugar hit from lower oil prices and improved supply chains we saw late last year is now entering a period of more balanced risks.

This is also helped at the margin by the small improvement in the US budget deficit, which is taking some of the steam out of the economy.

We expect the fallout from today’s numbers to persist very near term, as momentum funds lean against a vulnerable market.

This will open up opportunities to once again build exposure into long-duration positions.

The US now has less than four cuts this year (1%) and Australia less than two (0.5%), from almost six and three respectively at the end of 2023.

About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.

Find out more about Pendal’s fixed interest strategies here

About Pendal

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

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