Markets reassess US CPI report as Bitcoin gets into the swing of ETF trading

Some days you have to hold your hands up and say you don’t know what the clear drivers of market moves are. Thursday has been one of those days. A higher-than-expected inflation reading from the US, a key Fed member who said a rate cut is not on the cards for March, the launch of trading for 11 bitcoin ETFs and strange moves in the gold price, has not driven financial markets in the directions one would expect.

For example, after a stronger than expected inflation report, there was rally in the short end of the US Treasury yield curve. US inflation rose last month and was at the higher end of analyst estimates. Headline inflation rose by 0.3% MoM in December, while the annual index rose to 3.4%, up from 3.1% in November. The core index rose by 3.9% vs. a 4% annual rise in November, however, this was higher than analyst estimates. The question is whether the disinflation trends that we have seen are coming to an end, or if this was a blip and price growth can continue to fall in the coming months.

Are shelter costs telling the whole story?

Shelter costs were a major driver of higher inflation in the US last month, yet there are mixed signals coming from the rental market, which may be down to different methodologies for recording rental prices. The Rent Report, a monthly research report on renting trends in the US, has reported yearly declines in the US rental market. It reported that annual rents fell by 2.09% in November, the first time in more than 3.5 years that yearly price growth had dipped by more than 1%. The report said that the pace of monthly declines slowed in November, however, the current national median price for monthly rents was $1,967 in November, this compares to the peak in August 2022 of $2,054.

Undoubtedly, the slowdown in rents has been a slow process, but it appears that declines in the rental costs are not yet seeping into the official inflation figures. This could change in the coming months, and if rents continue to fall then it could put downward pressure on official inflation measures.

Why the market is still pricing in a March rate cut from the Fed

Elsewhere, if you look at super core inflation, and strip out healthcare, and shelter costs, then the rise in core prices suggests that the disinflationary narrative remains in place. Perhaps that is why the 2-year Treasury yield fell 14 basis points after the US inflation report was released. The yield is now at 4.25%, its lowest level of the year so far. Added to this, the 10-year yield also fell 5 basis points and is currently back below 4%.

US stocks also lacked clear direction on Thursday. After being close to its largest decline of 2024 so far, the S&P 500 managed to claw back early losses and close down a mere 0.07%, while the Nasdaq was flat, and the Dow Jones managed to move into the green. Stocks recovered at the same time as the market increased expectations for a rate cut from the Fed in March, with a 70% probability of a cut now priced in according to the CME’s Fedwatch tool.

Why the Fed could still cut rates in March

The market has one view, and nearly all economists believe that the market is wrong, and the Fed will maintain its hawkish stance, potentially until the second half of this year. But it’s worth remembering that economists are not always right. The market’s faith in a dovish Fed makes sense when you look at it from the following angle: over the last 30 years, the Fed’s average CPI rate has been 2.5%. Although inflation rose to 3.4% for December the core rate continued its decline, and we believe that the disinflation trend remains intact for now. Thus, taken from this angle, the Fed is closer to its average inflation rate, which supports rate cuts. Over time, inflation and the Fed Funds rate moves together, for obvious reasons. However, even as inflation has fallen in the US in recent months, interest rates have remained on hold. This means that the real interest rate in the US, the interest rate adjusted for inflation, has been in positive, and potentially restrictive, territory for some time. Of course, if the Fed hikes rates in March or June, in the long term it does not make too much difference, but for now it is driving market moves.

Looking at the gold price in more detail, it was also trading with a downside bias on Thursday, although it managed to stage a recovery by the end of the trading day. Even so, gold did not act as an inflation hedge when the CPI report came in stronger than expected. Overall, we think that the gold price could see more buying pressure if signs increase that the disinflation trend in the West is losing steam. If that happens, the gold price may attempt to re-take highs above $2050 from the start of the year.

EUR/USD waiting to pop out of tight range

Elsewhere, there was more hawkish talk from the ECB. This has reduced expectations for rate hikes from the European central bank this year. There had been 7 cuts priced in a mere 6 weeks ago, this has now been scaled back to just over 5 cuts this year. This hasn’t done much to help EUR/USD break out of its recent range between $1.10 and $1.09. Volatility in the FX market has been low so far in 2024, and this is mirrored in other markets.

Subdued volatility a risk factor for markets

The striking factor about 2024 so far from a trading perspective, is how subdued the Vix has been. The Vix measures volatility in the S&P 500 and is considered Wall Street’s fear gauge. It has been lingering near lows of 12 for most of the last 2 months and shows no sign of picking up steam. More uncertainty from the Fed, disruption to Red Sea shipping routes and now the prospect of US and UK airstrikes on Houthi rebels attacking ships on the Red Sea, has failed to move the dial for the Vix.

A subdued Vix can be a terrifying thing…

The first thing I learnt about financial markets was that the Vix does not stay subdued for long, that was back in 2007, and we all know what happened after that. While we are not on course for a credit crunch anytime soon, there are some risks that could trigger a spike in the Vix in our view: high levels of government debt and a financial accident triggered by the Fed failing to cut interest rates quick enough. The subdued level of the Vix is fuelling these strange, directionless market moves that we have seen in 2024, but do not get lulled into a false sense of security, as it may not stay like this forever.

Nikkei powered higher by the yen

As we have mentioned earlier this week, the Nikkei continues its march higher, and while volatility in the S&P 500 is subdued, it has picked up in the Nikkei, which is driving its push towards 1989’s record high just below 40,000. The Nikkei rallied 1.77% on Thursday, momentum is to the upside for this index, and it is also being helped along by a weaker yen.

To conclude, the main takeaway from today’s note is to watch volatility. It’s too low for my liking, and that is sending warning signs, and causing these erratic and strange moves in US indices, gold and even Bitcoin, which had risen nearly 5% to just below $49,000 at the start of its debut trading as an ETF, before falling back to $46,300 by the time the US markets closed.