News & Analysis

After the September Nonfarm payrolls report announced the death of the Fed pivot at November’s meeting, today’s inflation report put the nail in the coffin and poured cement over the top.

Core inflation printed at 0.6% MoM for the second consecutive month, exceeding expectations by 0.2 percentage points, with sequential core services coming in at 0.8% MoM. Meanwhile, the deflation story within the goods sector wasn’t as strong as markets were led to believe by the ISM manufacturing survey and yesterday’s producer price index, as it remained unchanged on the month despite a contraction in used car prices. If that weren’t bad enough already, headline inflation also ticked up, largely owing to the robust nature of core pressures as the upwards contribution on the month by higher food prices was completely offset by the decline in energy prices.

With core inflation printing above 7% on an annualised basis and no signs that wage growth is cooling as millions of available workers remain on the sidelines of the US labour market, the Fed is very much locked into hiking aggressively into year-end.

That could see the Fed fail to downshift to 50bps in December, the path implied at last month’s meeting. This view has been quickly shared by markets; the 2-year Treasury yield jumped 16bps higher on the day to reach a 15-year high of 4.45%, EURUSD fell over a percent to trade below 0.9650 for the first time since September, and swap markets increased their speculation on two back-to-back 75bp hikes from the Fed in November and December’s meetings. Not only that, but markets have also reassessed their terminal rate expectations, with the implied rate in the March 2023 swap jumping 20bps from 4.65% to 4.85%.

EURUSD plunges as near-term Fed pricing ramps up 

While the details of the CPI report suggest that inflation pressures in the US aren’t as robust as the top-line figures suggest, with such bleak overall figures, the silver lining is incredibly faint.

Core goods prices, which were largely expected to decline in September due to rising inventories and car auction prices suggesting used car prices are falling, came in flat on the month. While this was largely due to the fact that the substitution from new car demand to cheaper used cars has yet to filter through, it meant that the core goods inflation failed to take some of the heat out of the core services number. However, there are signs that core goods inflation will turn in coming reports. Not only will substitution effects in the car market start to weigh on new car price growth, but the inventory drag on prices in consumer goods, such as apparel, is likely to continue.

The problem therefore lies in core services, where most of today’s damage in markets stems from.

Not only was the top-line print of 0.8% MoM concerning, but the details also proved robust. While the 0.7% increase in shelter costs will take the headlines, the median services component exhibited price growth of 0.4% MoM. Additionally, the skew was very much to the upside, with an average increase in core services prices of 0.6% and the share of the core services basket posting inflation above 0.6% MoM sitting at 39%. With this portion of the core basket tending to exhibit greater persistence, the Federal Reserve will struggle finding an off-ramp in its hawkish hiking cycle over the coming months as core services inflation is set to remain high.

Distribution of core services CPI components skews to the right

What does today’s CPI release mean for FX markets?

The answer is simple. In short, it is too early to call the top in the year-to-date dollar rally, despite the obvious appetite within markets to position for the slowdown in the tightening cycle. With higher rates, lower equities, and fragile risk sentiment set to remain over the next two months at least, we continue to stand by our bullish USD forecasts.

That is, until Q1 next year, where we expect to see the rollover in US data to start testing the Fed’s resolve in keeping policy this restrictive heading into Q2.

For instance, the continued support to US rates will allow the yield premium on US bonds over Canadian bonds to widen, as Canadian core inflation shows signs of moderation and housing comes under more pressure compared to the US market given elevated leverage, which should result in less monetary tightening on the Canadian front. Until these dynamics reverse, we expect continued USDCAD to remain well-supported at elevated levels and now see the risks of our 3-month 1.40 forecast as tilted to the upside.



Simon Harvey, Head of FX Analysis
Jay Zhao-Murray, FX Market Analyst
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