Thursday’s CPI report was a big downside surprise as more signs of disinflation appeared across the economy. Core CPI rose 0.06% in June which brought the annualized rate to 3.27%. That’s the lowest rate since 2021. The big driver in the downside miss was shelter, which finally appears to be catching up to what we’ve been seeing across real-time shelter metrics. Importantly, shelter is still coming in at 5.1% annualized which is still exaggerated. My estimate is that this still has a long way to mean revert lower and likely heads to 3.5% or lower before the disinflation process is finished. At a 36% weighting in the CPI this remains a hugely important component and you’d need an absolute explosion in commodities or other services to offset this. It could happen, but for now the baseline estimate has to be for more disinflation. More broadly, core services were actually negative in June, the first time we’ve seen that since the pandemic began.

What’s it mean for the Fed?

This is all good news as we continue to see moderating inflation with stable employment levels. The big takeaway from all of this is that we’re getting closer and closer to the “all clear” on rate cuts. It reinforces my view, which I published last month, that the Fed should seriously consider a rate cut in July. I continue to think they won’t do that and that it could end up being a mistake. But Fed Funds Futures are now pegging September for a cut. I am still skeptical that that’s go time because of the election, but who knows? Jerome Powell has proven that he’s apolitical all the way and if the data deteriorates further he might feel the need to act regardless of the election. Either way I think the coast is clear for rate cuts at some point in 2024. It’s just a matter of when at this point.

At the same time, all of this increases the risk that the Fed could be behind the curve. They were late to raise in 2021 when the Taylor Rule was already saying they should raise rates and we’re seeing the inverse today. I’ve spoken before about the signs of weakness in the labor market, but the Fed seems intent on making sure inflation is dead before they move.

What’s it mean for asset markets?

The biggie is that this is all good for bonds going forward. I continue to think that we’ve reached escape velocity on government bonds of 5 years or less. If you’re managing T-Bill ladders then extending durations probably makes a good deal of sense here as you can start to lock in these high rates for longer. The uncertainty around equities will likely rise in the coming 6-12 months as we’ve ripped higher thanks to just a handful of tech names that could show they’re more economically sensitive than some think. We’re right in the crosshairs of the most dangerous part of the cycle for the Fed. We’ve got unemployment ticking up modestly, softening labor markets, frothy equity markets and high expectations that rate cuts will save everything, but the problem is that even if the Fed starts cutting in September their policy rate will still be extremely tight at 5%. It’s reasonable to assume that the Fed won’t achieve a “loose” policy rate until well into 2025 at the pace they’re likely to move now. That’s a long time away and there’s no way the Fed will move down as fast as they moved up unless they see an emergency. And if they have to respond with emergency cuts at any point in the coming years it means they made a policy mistake. Of course, stocks are very long duration instruments in our Defined Duration model so there’s not much point worrying about the 6-12 month moves of the stock market anyhow. But risk management is about trying to navigate the short-term risks of financial markets that include long-term instruments….

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