An inflation report from the United States sent a wave of relief across global markets yesterday, sending the dollar into a tailspin and igniting a stunning rally in risky assets amid bets that the Fed is about to dial down its rate increases. Inflation as measured by the CPI clocked in at 7.7% on a yearly basis, much cooler than the anticipated 8%, fueling hopes that the worst of the cost of living crisis is behind us.
Almost every category in the CPI basket simmered down, with sharp declines in medical care prices and used cars spearheading the improvement. The main drag was shelter, which continued to heat up. That’s good news though, because rents are simply playing catch-up with last year’s surge in house prices, so this backward looking metric shouldn’t be too worrisome for the Fed.
This dataset cemented the notion that the Fed will raise rates ‘only’ by half a percentage point next month, and pushed the terminal rate back below 5%. While investors interpreted this as a major victory, inflation is still running at almost four times the Fed’s target, so the war is not won yet and wagers that the end of the tightening cycle is imminent seem premature.
Hopes that inflation is finally moving in the right direction gave market participants the green light to load up on riskier assets, sparking an epic ‘buy everything’ rally. Stock markets went through the roof, with the Nasdaq gaining an astonishing 7.5% in one of its best days ever as yields on government bonds came crashing down. The only loser was the US dollar, which suffered sharp losses across the board. ‘Long dollar’ was probably the most crowded trade in the entire market, so the prospect of the Fed shifting into lower gear set in motion a mighty round of profit-taking.
Gold prices rose almost 3% and continue to build on those gains today. A sharp decline in the dollar and real US yields served as rocket fuel for bullion, which is priced in dollars and pays no interest to hold, making it more attractive as borrowing costs decline.
Admittedly, this seems like an overreaction - the Fed story hasn’t changed enough to warrant such dramatic moves in every asset under the sun. Stock market rallies exceeding 7% are usually not a healthy sign, and in fact generally occur within bear markets. Positioning most likely played a huge role in enabling these moves, with short positions in equities getting smoked and long dollar bets getting liquidated.
Yen comes back to life
Capitalizing the most on the US dollar’s troubles was the Japanese yen, which gained nearly 4% in a single session as interest rate differentials compressed to its benefit. A case can be made that the yen is setting up for a trend reversal, as the central bank divergence that brought the currency to its knees seems to be coming to an end.
Inflation in Japan is broadening out into categories beyond energy, the government is ready to roll out a $200bn stimulus package that includes incentives for companies to raise wages, and the BoJ chief opened the door for adjusting yield curve control last week.
That’s the strategy that decimated the yen, so loosening it could turn the tide, especially if that coincides with the Fed slowing down. Of course, the timing of any BoJ shift will depend on wage and inflation dynamics, and any real comeback in the yen might be a story for next year. Still, the narrative seems to be shifting.