Those who ascribe to ‘sell in May and go away’ would have avoided one of the two times this year where the S&P 500 declined more than five percent in single week (the other instance occurred in late January).
Many thought that U.S. inflation expectations peaked in March this year as April numbers saw a decline across both headline and core CPI. However, headline CPI reached another new high in May rising 8.6% year-over-year, a 40-year high as shown in Exhibit 1. Core CPI also remained stubborn on a month-over-month basis as it rose 0.6% showing no decline from April.
Exhibit 1 – U.S. Inflation Rates
Exhibit 2 breaks down CPI by weight to show which categories contribute most to CPI. Housing, which includes shelter, rent, household energy, and utilities has the largest weight in the basket at 42.4%. Transportation includes both private and public transport has the second highest weight at 18.2% followed by food & Beverage at 14.3%.
Exhibit 2 – CPI Basket Weights
Looking at each category in more detail, shelter prices have risen 5.4% YoY while rent prices have risen 5.1%. ‘Staycationers’ will find hotel prices are up 22.4% and getting to a destination by car (using gasoline) or airplane will be 48.7% and 37.4% more expensive respectively.
Exhibit 3 – U.S. Inflation by Category
June Fed Meeting
With the Federal Reserve meeting on June 15th, Refinitiv Workspace offers a look into market expectations on the path of interest rates. The July Fed Funds Future contract is currently priced at 98.5375 which implies a 1.46% policy rate. This translates to an 80% probability that the policy rate will be between 1.25-1.50% as per Exhibit 4. Users can access this app by typing “IRPR” in the search toolbar.
While a 50bp hike is already known, what is more noteworthy is the 20% probability at the time of writing that the policy rate may rise to 1.50-1.75% which would likely be a 75bp hike. (Update: On June 13th, the probability of a 75bp hike increased from 20% to 69% as per the IRPR app).
Exhibit 4 – Interest Rate Probability
Source: Refinitiv Workspace
Using Exhibit 4, we can look ahead to the July meeting which shows a 55% probability that the policy rate could land between 2.00-2.25%. In the end, we may see a total of 125bp in rate rises between the June and July meeting, whether it is a 75bp hike followed by a 50bp hike or visa-versa. Given the May inflation numbers, a case for the former is not out of the question.
Even if the policy rate is at 2.25% by July, it will still be off the mark when looking at the bond market as shown in Exhibit 5. The two-year bond yield (black line) hit a record high of 3.0%, which can be seen as a proxy for the policy rate. Furthermore, the spread between the U.S. 10y and 2y is at 9 basis points indicating a flattening yield curve.
We also overlay forward inflation expectations using the red and grey line which indicate inflation in five years’ time will still be above the 2% target, putting further pressure on the Fed to combat inflation.
Exhibit 5 – Bond Markets and Inflation Expectations
The personal consumption expenditure (PCE) index will be a key release in May as core PCE is a preferred measure used by the Federal Reserve to gauge inflation temperatures in the market. Core PCE peaked at 5.3% in February this year and dropped to 4.9% in April as per Exhibit 1. A rise in this indicator in May will certainly add more pressure on the Federal Reserve to combat inflation. We note that the next release of Core PCE is expected to be on June 30th, two weeks after the June 15th Fed meeting.
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