Inflation Divergence

In U.S. Exceptionalism we highlighted U.S. economic outperformance versus other developed markets. That outperformance seems to be coming at a cost – higher-than-expected inflation. Last week, the U.S. Bureau of Labor Statistics’ (BLS) latest Consumer Price Index (CPI) for all items rose 0.4% month-to-month in March, mainly driven by gasoline prices, shelter and other core services. Core CPI or CPI for all items less food and energy also rose 0.4% in March. Both headline and core CPI came in stronger than expectations. In year-over-year terms, the headline CPI edged up to 3.5% from 3.2% prior and core CPI stayed at 3.8%. Both inflation measures show that inflation remains elevated compared to the Fed’s stated target of 2% over the longer run.

The March CPI data was not a step in the right direction for the Federal Reserve. Fixed income investors who were expecting further disinflation in the U.S. and preparing for the start of the Fed’s easing cycle were disappointed. U.S. Treasuries sold off on the day, leading to higher yields across the Treasury curve. Market pricing for Fed policy rate cuts this year fell from 67 to 40 basis points (bps). On Tuesday, April 16th, Fed Chair Jerome Powell shifted his tone by saying “there has been a lack of further progress this year on inflation,” and “it is likely to take longer than expected to achieve that confidence” to lower interest rates.

The stalling out of disinflation this year appears to be mostly unique to the U.S. Shelter inflation in the U.S. is running close to 6% annually. In addition, non-shelter services inflation such as medical services and motor vehicle insurance might be re-accelerating. This week’s chart shows U.S. core CPI inflation accelerated to 3.9% over the last six months while Eurozone core inflation moderated to 1.8% during the same period.

The notable divergence in inflation in the U.S. versus Europe in 2024 has transpired into U.S. underperforming European duration with 10-year U.S. Treasury yields +77bps year-to-date (YTD) while German and French government bond yields are up only 47bps and 45bps, respectively. Expectations for monetary policy for the Fed and European Central Bank (ECB) have also decoupled, with the ECB expected to kick off its rate cutting cycle in June while the Fed is now expected to begin cutting rates in September or later. Wider interest rate differentials between the U.S. and Europe have supported the USD versus the Euro recently, with USD rallying to near 6-month highs. Perhaps more concerning for investors, the hotter inflation prints saw a rise in interest rate and equity volatility, which combined with the stronger USD has led to a tightening in financial conditions. So far in 2024, inflation in the U.S. remains a key variable for global financial markets.