Hi YXI Friends,

The big headline today was the surprising slowdown inflation is having, that made the Fed’s latest set of Dot Plot look pretty foolish.

Both the Headline CPI and Core CPI (i.e. CPI excluding food and energy) came in lower than expected.

We will dive into the details of this report, its potential impact on the monetary policy, and the post-CPI market reaction.

DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.

1. Headline CPI turning negative MoM

Headline CPI fell by 0.1% MoM in June. This was the first occasion since May 2020, during the COVID turmoil. Now Headline CPI stands at 3.0% on a YoY basis.

The main culprit is the energy basket, which has now printed two consecutive -2% MoM prints. Energy prices fell across the board.

This was slightly surprising given that WTI ($USOIL) rallied from $72 p.b. to $82 in June. Historically, higher WTI prices were associated with higher headline CPI.

2. Core inflation and Services ex-rent also cooled

The Fed should be happy to see that Core CPI slowed down for the fourth month in a row, increasing by only 0.1% from the previous month. It brings the YoY figure to 3.3%.

Services inflation ex-rent came in flat MoM for a second month, reversing the rising trend from the previous 8 months.

The key chart here is the 3-month annualised rate of the Headline, Core, and Services ex-rent readings. You can see below that they are falling very fast! On a 3-month annualised basis, the Headline and Services ex-rent are both below 1%.

3. Shelter & motor vehicle insurance still dominate

Rent, Owner's’ equivalent rent (i.e. an imaginary payment that house owners make), and Motor vehicle insurance still account for an overwhelming 80% of the total CPI.

The good news is that all three components are trending down.

The problem is that while these components have an outsized influence on the overall CPI, they all have significant lag effects.

Rent is primarily driven by housing, which falls with high interest rates, even if it takes time. Car insurance is affected by the surge in car ownership during covid, rising costs of parts and labour due to supply-chain bottlenecks, and (believe it or not) a surge of motor accidents.

4. Rates bull-steepened

Yields fell across the curve post the CPI print, but the heaviest swing occurred in the 2025 and 2026 tenors, down 12-16bp.

Fed funds futures now see a base scenario of 2 cuts in 2024 (September and December), with a 50% chance for an additional cut to occur in November.

Contrast this with the 1-cut median Dot Plot released only in the latest June FOMC.

5. The Fed should cut in July

Prior to the CPI release, Powell kept repeating that the Fed was not yet confident enough inflation was on the sustained path to 2%. But this report must have overshot the expectations of the even the more pessimistic members of the FOMC.

Combined with the latest Nonfarm Payrolls data, the Fed should start cutting in the upcoming July FOMC and get ahead of the expectation curve, rather than play catch up. They can even do one-and-done for 2024.

My view is that cutting-one-and-see should be a superior option than seeing-3-more-and-be-late. The global markets are so well drilled in the central bank “data dependency” approach, I don’t think the Fed risks miscommunication if they cut now.

6. Megacap stocks fell, Growth names rallied

All of the Magnificent 7 names fell at least 2% today, with TSLA crashing by 8.44% on the back of a delay in the Robotaxi demo.

While SPY and QQQ dropped, IWM rose by a stunning 3.5%. The theory goes that additional rate cuts should help prop up the valuation of growth names.

This because they heavily rely on the free cash flows generated in the far future, which are sensitive to the discount rates. (Lower discount rates, higher NPV of free cash flows, and higher valuation). Moreover, looser financial conditions help bring excess liquidity into these smaller caps, which need substantial investment and growth before they become profitable.

However, should an additional 25bp cut in 2024 really translate to materially higher valuation? I think the maths does not match the narrative yet.

7. A breakdown of CPI components for May and June

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References