Inflation cooled further in June leading markets to believe Fed rates will soon follow.
For the first time in a long time the Consumer Price Index fell on a monthly basis in June, declining 0.1% from May. This was welcome news for the financial markets which have been anxiously awaiting signs that inflation is under control and that the Fed can finally start lowering interest rates.
Overall inflation was 3 percent in June on a yearly basis, down from 3.3 percent in May, and softer than the 3.1 percent that economists had forecast in a Bloomberg survey.
After stripping out food and fuel prices for a sense of the underlying trend, the “core” price index climbed 3.3 percent compared to a year earlier. This annualized increase in the core rate was the smallest since April 2021.
This encouraging inflation data provided clear evidence that inflation is slowing in a meaningful way–exactly the kind of progress that Fed officials have been hoping to see as they contemplate when to begin cutting interest rates. The central bank has held borrowing costs at 5.3 percent for the past year, a relatively high setting that is meant to cool the economy by weighing down demand for big purchases that require loans, like houses and cars.
While policymakers came into 2024 expecting to cut rates several times, a spate of stubborn inflation numbers early in the year has kept them on hold. But now evidence is mounting that inflation is truly coming under control, which could pave the way for a rate cut in the coming months.
“This is the inflation report that we’ve been waiting for,” said Neil Dutta, head of economic research at Renaissance Macro. “The important story for the Fed is that this is happening at a time when the unemployment rate has been going up for the last three months, and the trade-offs are shifting.”
Stock Rotation
Stocks rallied in response to the inflation news, which was widely expected. However, what was not as widely expected were the stocks that benefited the most. Unlike recent history, tech stocks were not the big winners. Instead, value stocks led the charge higher.
Specifically, investors were piling into the industrial and consumer stocks that they had ignored most of the year in favor of tech. As a result, the Dow Jones Industrial Average posted its largest daily increase in a year.
“The ‘great rotation’ trade which kicked off last Thursday appears to still have legs,” said Nathan Peterson, director of derivatives analysis at the Schwab Center for Financial Research.
This move could be supported by expectations of early business cycle positioning as the Fed shifts into a more accommodative stance, he added. The prospect of lower borrowing costs often drives investors toward cyclical sectors like industrials and consumer discretionary, as well as rate-sensitive areas of the market that could benefit.
The small-cap Russell 2000 index has now risen more than 11% in the last week and the S&P 500 Equal Weight Index, which assigns all stocks an equal weight rather than weighing them by market capitalization, has gained 3.5% in the last four days. Both had spent most of the year lagging behind the market cap-weighted S&P 500, which has become dominated by mega-cap tech stocks.
“The improvement in breadth is notable, but frothy sentiment is back as a risk,” said Kevin Gordon, senior investment strategist at Schwab. “The market’s recent rotation is a net positive, but we can’t rule out further choppiness—or a meaningful pullback— for stocks since investor sentiment is now running increasingly hot.”
Gordon added that the percentage of S&P 500 members outperforming the index over the past year is still at a record low of just 25%. “If that doesn’t improve as the index continues to move higher, it will keep the risk of a pullback elevated,” he said.
Outlook
Fed officials are focused on not overdoing their effort to cool the economy. They are determined to fully stamp out inflation, but at the same time, they do not want to cause a recession in the process.
“If we loosen policy too late or too little, we could hurt economic activity,” Jerome H. Powell, the Fed chair, said during congressional testimony this week. “If we loosen policy too much or too soon, then we could undermine the progress on inflation. So we’re very much balancing those two risks, and that’s really the essence of what we’re thinking about these days.”
This is typical Fed-speak for keeping their options open. That said, it is possible that the Fed might start cutting interest rates at its meeting this month, which takes place July 30-31. However, the more widely held belief is that the central bank will lower at the meeting after that, on Sept. 17-18. In fact, while Fed chairman Powell avoided identifying a specific month when the Fed might begin to cut interest rates during his two days of testimony last week, he did little to push back on growing expectations that a reduction could come in September.
Indeed, the stock and bond markets are both signaling that the Fed will begin lowering interest rates soon and that the economy will avoid the so-called hard landing (recession) that often follows a rate tightening cycle like that which started in 2022. This is a difficult feat for any Federal Reserve, and one that should be celebrated by all should it come to pass. And it is looking increasingly likely that the Fed has managed to thread this needle.