Stocks Fall as Bond Yields Rise After CPI Data: Markets Wrap

(Bloomberg) — Stocks got pummeled after a faster-than-anticipated inflation report fueled bets the Federal Reserve will move gradually with rate cuts, which could diminish the odds of a soft economic landing.

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All major groups in the S&P 500 retreated, with financial, industrial and energy companies leading losses. The benchmark gauge dropped more than 1%. Treasury two-year yields rose as much as 10 basis points — before paring the move. Swap traders fully priced in a 25-basis-point Fed cut at next week’s gathering and see only a small chance for a half-point reduction.

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“The firmer-than-expected August core CPI inflation print will reinforce inertia on the Fed and make it harder for Chair Jerome Powell to deliver a 50 basis-point cut in September,” said Krishna Guha at Evercore. “We continue to think a starter 50 basis-point cut is the right play and might even now win out. But the odds have moved against this, and risks to markets and the soft landing are higher as a result.”

The so-called core consumer price index — which excludes food and energy costs — increased 0.3% from July, the most in four months, and 3.2% from a year ago, Bureau of Labor Statistics figures showed Wednesday. The three-month annualized rate advanced 2.1%, picking up from 1.6% in July, according to Bloomberg calculations.

The S&P 500 fell 1.3%. The Nasdaq 100 lost 1%. The Dow Jones Industrial Average sank 1.6%. The KBW Bank Index slumped 2.5%. The Russell 2000 Index slid 1.4%.

The yield on 10-year Treasuries declined two basis points to 3.63%. The dollar wavered.

Wall Street’s Reaction to CPI:

The August CPI report was like the Hippocratic Oath, it did no real harm to the financial markets. It provided further evidence to the Fed that they should move by 25bps next week. A 50bps cut should not be in the cards as the recession call needs further deterioration in the labor market and the Fed likes its optionality.

Particularly in light of the recent softness in the labor market, the data should allow the Fed carte blanche to start cutting rates on September 18th.

While this inflation report is good news for stock market bulls, it might not provide the same relief to equities we have seen in previous ‘not-too-hot’ reports. The inflation report has long been the most critical number in the market, but it has recently been overtaken by the concern for a cooling job market and recession worries.

The CPI report suggests the Fed begins its easing policy with 25 basis points rather than a hoped for 50 basis points.

Inflation continues its path towards two percent, albeit at slow and steady pace.

Today’s print should assuage markets that deflation caused by an economic scare has been avoided, at least for now.

Core CPI was slightly higher than expected. However, this shouldn’t change the direction of travel for the Fed next week, but it probably keeps them at a 25 basis point cut rather than a 50 basis point cut.

Interest rate markets are backing away from the expectations of aggressive rate cuts in the immediate aftermath of today’s CPI release.

Today’s CPI report is good enough for now. Inflation is moving in the right direction for the Fed to cut 25 basis points this month, but shelter costs remain a concern. On the other hand, we’ll probably get some relief next month from the recent decline in energy prices.

The numbers aren’t runaway dovish, but they confirm the cooling process remains in effect. Attention could now shift from the Fed as a catalyst toward earnings and the election cycle.

It would be wrong to characterize today’s CPI as a bad report. There were big increases in some components, but the most nettlesome — the OER and airfares — came on the heels of several months of good news. In the meantime, inflation is marching lower, as is evident in the declining year-on-year CPI inflation rate in the chart, above.

Nevertheless, where it was a stretch that even surprisingly low inflation would encourage the Fed to cut 50bp before this release, it is an even bigger stretch to expect 50bp now, given inflation was not just a little worse than expected, but the monthly increase in the core CPI was biggest since April.

This isn’t the CPI report the market wanted to see. With core inflation coming in higher than expected, the Fed’s path to a 50 basis point cut has become more complicated. The number is certainly not an obstacle to policy action next week, but the hawks on the committee will likely seize on today’s CPI report as evidence that the last mile of inflation needs to be handled with care and caution – a formidable reason to default to a 25 basis points reduction.

This month’s inflation figures reiterate the likelihood of a slow cutting cycle – disinflationary pressures are strong enough to help ensure against a price spike, so the Fed can opt for a gentle pace to manage risks to the labour market and avoid a recession.

Slow and steady should win the race.

Core inflation beating expectations in August should tilt the Fed toward an initial 25 bps rate cut next week.

Today’s modestly less favorable print will not prevent the Fed from beginning to normalize interest rate policy next week, but it could re-frame the debate around the monetary policy path over the next several quarters.

Further signs that inflation may be a bit stickier than previously thought would likely result in a slower and shallower cutting cycle. This would be a disappointment to short-term bond markets that have priced over 250 bps of rate cuts by the end of 2025.

Much of the US inflation data for August was as anticipated, but the core level was higher than hoped, driven by housing costs. The likelihood of a 0.5% cut from the Fed next week has taken a big knock with this number, but it won’t be enough to stop the Fed cutting at all. They are still walking a tightrope between beating inflation and maintaining growth, which will mean that more moderate policy measures will prevail for now. The Fed still has plenty of room for policy shift this year and next.

The Fed is widely expected to cut rates by 0.25% next week, and today’s more-or-less on-target CPI reading keeps that very much in play. That may disappoint those investors hoping for a bigger cut, but with inflation seemingly under control, the markets will likely turn their focus back to the economic growth side of the equation—especially the employment picture.

Wednesday’s CPI came in as expected giving the Federal Reserve the go ahead to still cut interest rates at the September meeting, albeit by a more shallow 25 basis points. The Fed wants to finally initiate a rate cutting cycle to get in front of increasing unemployment levels and in order to calm fears that the Fed may already be behind the curve.

While we’ve seen a slight pullback in stocks as of late with choppy earnings and economic data, we would expect more smooth sailing post this initial Fed rate cut and post-election, as uncertainty fades and investors start to price-in 2025 earnings.

All clear for launch – the Fed has the green light to cut 25 bps next week, given that the inflation report was in line with expectations. It’s possible that some will be disappointed that there wasn’t a lower-than-expected inflation reading, which might have given the Fed more room to cut 50 bps, but most of the Fed speakers have already telegraphed their desire to start slowly and not begin with a jumbo cut.

Going forward, the risks are clearly weighted toward slowing growth and a deteriorating labor market, and that’s why there are still four 25 bps cuts priced in with only three meetings left in the year (i.e. implying at least one of the three meetings would have a 50 bps cut), but if the economy continues to slow – and not drop into an abrupt recession – the Fed will be able to cut at a measured, 25 bps-per-meeting pace.

Given the current situation, with a Fed cutting rates, unemployment close to multi-decade lows and an expanding (although slowing) economy, the market should be able to reclaim all-time highs, once we get past the volatility that precedes most presidential elections.

Key events this week:

Japan PPI, Thursday
ECB rate decision, Thursday
US initial jobless claims, PPI, Thursday
Eurozone industrial production, Friday
Japan industrial production, Friday
U. Michigan consumer sentiment, Friday

Some of the main moves in markets:

Stocks

The S&P 500 fell 1.3% as of 10:17 a.m. New York time
The Nasdaq 100 fell 1%
The Dow Jones Industrial Average fell 1.6%
The Stoxx Europe 600 fell 0.3%
The MSCI World Index fell 1%
Bloomberg Magnificent 7 Total Return Index fell 0.9%
KBW Bank Index fell 2.5%
The Russell 2000 Index fell 1.4%

Currencies

The Bloomberg Dollar Spot Index was little changed
The euro was little changed at $1.1012
The British pound fell 0.4% to $1.3023
The Japanese yen rose 0.7% to 141.45 per dollar

Cryptocurrencies

Bitcoin fell 3.3% to $55,702.89
Ether fell 3.7% to $2,290.27

Bonds

The yield on 10-year Treasuries declined two basis points to 3.63%
Germany’s 10-year yield declined three basis points to 2.10%
Britain’s 10-year yield declined seven basis points to 3.75%

Commodities

West Texas Intermediate crude rose 0.9% to $66.35 a barrel
Spot gold fell 0.5% to $2,504.43 an ounce

This story was produced with the assistance of Bloomberg Automation.