Will US CPI Decline Enough to Alter Fed's Path?

Inflation in the US is expected to come down dramatically, but with the core rate still high, it might not be enough to shake the Fed from its rate hiking path.

Getting the Market Ready

Wednesday is expected to be the market's big event of the week, with the much-anticipated release of June CPI figures for the US. This is the last major macro data before the Fed gathers for its July meeting (the first look at Q2 GDP is the day after the FOMC decision). Given the underperformance in the jobs numbers reported last Friday, much could be riding on this data release. Over 90% of traders expect a rate hike later this month, but they still aren't convinced the Fed will follow through with its second rate hike this year since most traders still see rates topping out at 5.5% this year.

One key factor of the NFP report was that average wages increased at 4.4%, above the latest inflation report. The expectations are that inflation is even lower now. The tightness in the labour market could be the main driver of inflationary pressures. The core rate is elevated, more than doubling the target rate. As headline inflation has been coming down, the gap with the core rate keeps getting wider. Logically it follows that even if inflation falls, a lack of progress in the core could keep the Fed on track to hike and end up disappointing the market again.

What's the Data Outlook?

US June headline inflation is expected to fall to 3.2% from 4.0% reported in May. Core inflation is not expected to have such a dramatic drop, coming down to 5.0% from 5.3% prior. While both are trending in the right direction, the Fed might not be willing to ease up. With such a strong consensus about the July meeting, what could move the market the most is if inflation stays high enough to convince traders that the Fed will actually go through with the second rate hike.

Across the Atlantic, the ECB seems to be in somewhat of the opposite problem. After the economy stagnated over the winter, but inflation was still very high, traders expect the ECB to continue to hike. President Christine Lagarde and Vice President Luis de Guindos were in the press recently, insisting that rates will keep increasing. But, with the latest inflation data pointing to the Eurozone not having inflation under control, the issue for the Euro might be real rates. As inflation comes under control in the US, real rates have risen and have already turned positive. Real rates in the shared economy are still negative. Even if the ECB hikes in parallel with the Fed, the slower deceleration in inflation in Europe could mean that real rates still make the dollar a more attractive candidate, keeping the EUR/USD under pressure.

EURUSD at Decision Point

The long-term structure of EURUSD resembles a wedge and a triangle (symmetrical or ascending), depending on whether bulls can reach or recapture $1.1096 and how price action progresses post-breakout. Lack of momentum could print a triangle, with the round support at 1.09 and the swing support at 1.0834 being crucial before further advances, whereas further longs past the top would raise the probability of a wedge.

Bulls can expect the peaks of 1.1033 and 1.1096 to resist, with a break higher opening up 1.13 via 1.1185. On the flip side, losing 1.0834 will expose the throughs of 1.0635 and 1.0516, increasing the chances of additional declines.

Source: SpreadX / EURUSD

Key Takeaways

While inflation is expected to decrease significantly, the core rate remains high, which might not be enough to sway the Fed from its path of rate hikes. Although over 90% of traders expect a rate hike later this month, there is doubt about a second rate hike this year. The tight labour market is likely driving inflation, and despite a decline in headline inflation, the widening gap with the core rate may keep the Fed on track to hike rates, potentially disappointing the market once again. The ECB faces the opposite challenge. Traders have been expecting the ECB to continue raising rates after a stagnant economy but high inflation, with the issue lying in real rates. Even if the ECB hikes rates alongside the Fed, the slower deceleration of inflation in Europe could add pressure on EUR/USD.