U.S. core inflation slightly below expectations fails to change market view; bond traders stick to bets on rate hikes this year.

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The core inflation data for May in the United States was slightly below expectations, providing the Federal Reserve with limited breathing room, but the market's expectations for a rate hike this year have not been substantially shaken.

Data released on Wednesday showed that core CPI in May rose 0.2% month-on-month, lower than the 0.3% expected by economists surveyed by Bloomberg. The bond market remained calm, and interest rate swaps indicate that traders are still pricing in a Fed rate hike before December. The dollar softened slightly, and the yield on the two-year US Treasury fell from about 4.13% before the data release to 4.11%.

However, overall inflationary pressure remains prominent. CPI in May rose 4.2% year-on-year, marking the largest increase in three years, mainly driven by a surge in oil prices. The market's expectations for the timing of rate hikes have adjusted slightly: according to Reuters data, the probability of a September hike dipped from about 50% to 45%, while the probability of an October hike remained unchanged at about 60%.

Core CPI slowdown provides “breathing room”

The slowdown in core CPI growth in May has temporarily eased concerns in the market that the Fed may be forced to hike rates quickly. Dan Carter, senior portfolio manager at Fort Washington Investment Advisors, said: “The main takeaway is that this gives the Fed a little breathing space. If there’s another overheating month, the pressure to raise rates will increase significantly. The current data is just mild enough to allow them to continue to wait and see.”

Prior to the data release, traders in the SOFR options market, which is highly sensitive to Fed policy, had already built large positions betting on multiple rate hikes in the coming months. Some traders, after last Friday’s strong jobs report, even started positioning for a rate hike as early as September. The mild performance of this CPI data has tempered these aggressive expectations somewhat, but the overall direction toward a rate hike this year has not changed.

Oil price shock drives up overall CPI

Core CPI excludes food and energy to isolate the disruptive effects of short-term energy price fluctuations on overall inflation. The overall CPI in May rose 4.2% year-on-year, mainly driven by a sharp surge in oil prices due to the situation in the Middle East. This event has reshaped bond market pricing since the end of February and completely disrupted earlier expectations that the Fed under Chairman Kevin Warsh would initiate rate cuts.

The relative mildness of the core data indicates that the oil price shock has not fully spread to broader consumer prices. But David Kelly, Chief Global Strategist at JPMorgan Asset Management, said in an interview with Bloomberg TV: “An inflation rate above 4% is not pleasant, and there’s currently no reason to ease policy. But I think the Fed can hold steady.” He added that with the inflation rate roughly matching unemployment targets, Warsh “has no intention of leading a rate cut.”

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