Inflation trends lower, driving expectations for a September rate cut

The June Consumer Price Index (CPI) report provided a more positive outlook on inflation than economists had anticipated. The CPI dropped 0.1% from May, slowing the annual rate of inflation to 3% from the previous 3.3%. This decline was the first month-on-month drop since May 2020 and the slowest annual increase since early 2021. The actual figures outperformed the expectations, which predicted a 0.1% monthly increase and a 3.1% annual gain. The cooling inflation was largely driven by falling gas prices and a decline in new and used car prices.

The news has helped set up an interesting dynamic as we have seen money move out from the market leaders (NVDA, AAPL, AMZN, etc) and into small caps. This has set up a dynamic were we see advancing stocks outperform declining stocks by 4 to 1, yet indices are under pressure. This just highlights the concentration in these megacap tech plays.

The core CPI, which excludes the volatile food and energy prices, also showed more positive results than expected. It rose by only 0.1% from May, marking the slowest monthly increase since August 2021, and the annual rate of core inflation decreased to 3.3% from 3.4%. This marks a fresh three-year low for core inflation. The better-than-expected report bolstered hopes for a potential Federal Reserve rate cut in the near future, making borrowing money less expensive and providing relief to consumers who have been grappling with fast-rising prices for three years.

One of the critical areas highlighted in the report was the shelter index, which has been a significant concern for the Federal Reserve. The shelter index rose by just 0.2% in June, the slowest monthly increase in three years. On an annual basis, shelter-related prices increased by 5.2%, the coolest reading in two years, although still above the overall inflation rate. This moderation in shelter costs is seen as a positive development, given that shelter inflation makes up about one-third of the overall CPI and has been one of the most persistent components of inflation.

The market reacted to the report with mixed results. Initially, U.S. stocks jumped on the news but quickly gave up those gains, with the Dow falling 90 points, the S&P 500 dipping into negative territory, and the Nasdaq remaining flat. U.S. Treasury yields fell, which could benefit consumers as loans like mortgages are tied to the 10-year yield. Investors are increasingly confident that cooling inflation will allow the Federal Reserve to cut interest rates in the coming months. According to CME Group’s FedWatch Tool, there is now an 89% chance of at least one rate cut by the September 17-18 Fed meeting, up from 73% the previous day.

The easing inflation has also prompted traders to adjust their investment strategies, shifting from big tech stocks to less-favored market segments like small caps and industrials. This adjustment reflects expectations that a potential rate cut could serve as a catalyst for these sectors to perform better. The report also showed that real average hourly earnings for workers increased by 0.4% monthly, though the annual increase was just 0.8%, indicating that wage gains are still moderate despite the cooling inflation.

Fed Chair Jerome Powell has indicated that the cooling labor market and easing inflation might justify rate cuts sooner rather than later. With the June CPI report showing better-than-expected results, the Federal Reserve appears to be one step closer to considering a rate cut in September. However, a lot can change between now and the next Fed meeting, and the Fed will continue to monitor economic indicators closely. If inflation remains under control, the Fed's reasoning for maintaining high rates may no longer hold, paving the way for potential rate cuts in the near future.