Mixed CPI Signals Cloud Fed's Rate Cut Outlook: Opportunities in Tech and Treasuries?

The May 2025 Consumer Price Index (CPI) report delivered a nuanced message to markets: headline inflation rose modestly to 2.5% year-over-year, while core inflation inched up to 2.9%. Yet beneath the surface, the data revealed a fractured narrative—one that complicates the Federal Reserve's policy path and reshapes investment opportunities.

The surprise came not from the numbers themselves but from their composition. While shelter costs (up 0.3% monthly) and energy prices (up 0.7% monthly) fueled inflation, other categories, such as food (-0.1% monthly) and tariffs-affected goods, remained subdued. This unevenness suggests that the Fed's wait-and-see approach is justified, but it also weakens the case for an imminent rate cut.

The CPI's Mixed Signals
The May report highlighted two critical divides:
1. Core vs. Headline Inflation: Core CPI, excluding volatile food and energy, rose more sharply than headline inflation, signaling underlying price pressures. However, the headline figure was held back by falling gasoline prices and soft food costs.
2. Tariff Effects: Delayed but Looming: President Trump's tariffs have yet to materialize fully in CPI data. Goldman Sachs noted that tariff pass-through to consumer prices is still nascent, with sectors like IT goods and household items showing early signs. Yet broader inflationary pressures remain muted, giving the Fed room to stay patient.

Fed Policy: On Hold, but Markets Overreach
The Fed has maintained its pause since March 2025, with the federal funds rate anchored at 4.25%-4.50%. While markets had priced in a 99% probability of no June hike, they also anticipated a 20% chance of a July rate cut. The May CPI's underwhelming inflation data—combined with strong April nonfarm payrolls (+139,000)—undermine this expectation.

The Fed's dilemma is clear: inflation is too high to justify cuts, but not high enough to warrant further hikes. Chair Powell's “restrictive stance” language remains intact, but the path to easing is now cloudier.

Investment Implications: Rate-Sensitive Plays
The weak case for an immediate Fed cut creates opportunities in sectors that thrive under stable rates:

1. Technology Stocks:
   Tech firms, particularly those with high growth profiles, often rely on low discount rates. While higher rates pressure valuations, the absence of an imminent cut removes one overhang. Companies like Microsoft and Amazon, with robust cash flows, could outperform if markets reassess their discounted cash flow assumptions.

2. U.S. Treasuries:
   The bond market has priced in a Fed cut, but if the Fed stays on hold, yields could drift lower. A flattening yield curve (e.g., the 2-year/10-year spread) may favor long-dated Treasuries, which have underperformed in recent quarters.

3. Sector Rotation:
   Avoid sectors sensitive to rising input costs (e.g., discretionary retail) and focus on defensive plays in utilities and healthcare, which benefit from stable rates and inflation-linked pricing power.

Risks to Consider
- Tariffs' Lagged Impact: If second-half data shows tariff-driven inflation surging, the Fed may face renewed pressure to tighten.
- Labor Market Resilience: A stronger-than-expected June jobs report could further delay easing.

Conclusion
The May CPI's mixed signals have reshaped the Fed's calculus. While inflation remains above target, its uneven trajectory and delayed tariff effects weaken the case for an immediate rate cut. Investors should pivot to rate-sensitive sectors like tech and Treasuries, which stand to benefit from policy stability. However, vigilance is key: markets will remain volatile until the Fed's path crystallizes.

In this environment, the mantra is clear: favor sectors that thrive in low-rate environments and avoid overpaying for assets relying on Fed easing. The Fed's patience may yet be tested, but for now, the data argues for caution—and opportunity.