Goldman: Rates Remain Biased Higher Despite Twin Inflation Misses

Goldman Sachs note that “U.S. inflation cooled more than forecast in July. While a decline in headline CPI on account of lower gasoline prices was anticipated, there were surprises in a range of categories in the core measure, with lower airfares and used car prices contributing significantly to the softening. Trimmed measures remain elevated, however, and our economists note a sequentially slower but still elevated pace of shelter inflation. Overall, despite a “policy relief” trade playing out across asset classes following the CPI report, we do not believe the categories contributing to the downside surprise justify a relaxation of either Fed pricing (barring a lowering of the probability of a 75bp hike in September) or lower levels of rates at longer maturities.”

• “Indeed, the repricing in the rates market has been more measured compared to other asset classes, with longer maturity yields drifting higher; this steepening is also apparent in OIS forwards. The move can be rationalized in the following way: a more rapid near-term deceleration in price pressures reduces the market-implied odds of large hikes, lowering pricing for some near-term meetings. However, given the continued tightening of the labor market and still sticky trimmed inflation measures, we believe the Fed will likely have to raise the policy rate at least to our economists’ baseline, if not more. Indeed, less front-loading of hikes could mean steepening either because it extends the hiking cycle or because a more measured pace of policy rate increases would allow the Fed to calibrate policy better.”
• “The latter would reduce the risk of overshooting too far into restrictive territory, thereby lowering the odds of future cuts. If the coming months continue to feature a mix of stronger-than-expected growth/jobs data and rapidly cooling inflation with still sticky (large) components in the core measures, we could see front end forward curves steepen further. However, if as we expect, activity data weaken more than consensus, we could see a resumption of curve flattening.”