Three months of continuous heat inflation data have weakened Wall Street's confidence that a series of interest rate cuts is about to begin. They now hope that the fourth CPI data this year will show “good momentum.”

In the days leading up to the release of the CPI report on Wednesday, optimism about a soft landing in the US economy once again swept across the market. Federal Reserve Chairman Powell maintained his hopes of cutting interest rates after the Federal Reserve's most recent policy meeting. Subsequent data showed that the pressure on employment and wage growth has eased, helping push US stocks back to record highs.

Continued inflation has been a major problem plaguing investors in recent months. At the beginning of 2024, traders were betting that the Federal Reserve would cut interest rates more than 6 times during the year, but when the CPI continued to be higher than expected, they had to quickly reduce their bets and push US bond yields to the highest level since November last year.

Many investors say the April non-farm payrolls report allayed some of their concerns, as a cooling labor market should eventually cause prices to rise more slowly. Now they just need actual inflation data to support this view.

Gennadiy Goldberg, head of US interest rate strategy at TD Securities, said, “The CPI report may greatly further drive the statement that the Federal Reserve will cut interest rates this year.”

Compared to US stocks, are US bonds better?

There is a correlation between US stocks and US bonds. The yield on US bonds is largely influenced by investors' short-term interest rate expectations set by the Federal Reserve, while stock prices are affected to a certain extent by the risk-free returns investors can obtain from holding US Treasury bonds until maturity.

The Dow Jones Industrial Average has risen 4.5% this month, less than 1% from the record set at the end of March. The rise in US bond prices drove the 10-year US Treasury yield down to around 4.5% from 4.7% at the end of April.

Many investors believe that if inflation slows down, the increase in US debt will be greater than that of US stocks. Although the latter is close to an all-time high, the yield on 10-year US Treasury bonds is still far above the level of less than 4% at the beginning of the year.

Over the past few years, returns on US bonds have been disappointing, as interest rates have climbed higher than investors expected and have stayed at this level longer than expected. Despite this, as soon as there are signs of slowing inflation, investors will quickly buy US bonds and rush to lock in 4%-5% yield before the Federal Reserve starts cutting interest rates.

Ed Perks, chief investment director of Franklin Income Investors, said that if the data shows a slowdown in inflation, he expects the yield on short-term US bonds to fall by 0.2-0.25 percentage points, and the yield on long-term US bonds may drop by 0.1-0.2 percentage points.

At the same time, he said, given current stock valuations, “it is more challenging to see a sharp rise in the stock market.” He added that for the same reason, the stock market may have more room to fall if inflation is higher than expected again.

“Inflation will be tricky”

US inflation has fallen sharply from its peak in 2022. The problem is that the PCE price index, which is favored by the Federal Reserve, has yet to return to its 2% target. The year-on-year growth rate of the core PCE price index fell from 4.9% at the beginning of the year to 2.9% at the end of last year. However, it has remained stagnant since then, at 2.8% in March.

The CPI report released on Wednesday will provide investors with a better perspective than usual to understand what the PCE price index will look like later this month. This is because the PCE Price Index includes some CPI and PPI data segments.

Normally, CPI data will be released before the PPI report, which leaves investors with some uncertainty about the indicators favored by the Federal Reserve. However, this month's PPI data will be released first on Tuesday, so investors can quickly calculate how much the PCE price index will grow in April on Wednesday morning.

Many economists are still optimistic that inflation will fall again. They pointed out that commodity inflation has slowed to the level desired by the Federal Reserve. Official housing inflation indicators have remained high, but economists still expect these indicators to ease somewhat and be more in line with the private sector's measures of new rent increases.

Inflation for other types of services tends to slow as it rises and falls. However, recent reports suggest that the labor market is cooling down as a positive sign, as labor costs are often the main driver of price changes for such products.

Furthermore, economists point out that inflation in certain types of services often lags behind that of related goods. As a result, given what new and used car prices have already emerged, many people expect the rise in car insurance or maintenance costs to slow in the next few months.

However, no one currently underestimates the possibility that inflation will unexpectedly occur in any month. George Mateyo, chief investment director of Key Private Bank, said that considering that poor economic reports may damage the US stock market and bond market, it is still wise to hold unconventional assets such as real estate, inflation-protected bonds, or international stocks to hedge against the risk of overheating data. He stated:

“We think inflation is going to be a little tricky.”

Editor/Jeffrey