A hot inflation report hits short-term bonds

Headline inflation came in at 3.1 per cent in January and core prices rose by an uncomfortably hot 0.4 per cent on the month. Bond bulls were caught out. The front end of the US yield curve repriced at once, and two-year Treasury yields jumped.

The setback came after a run of friendlier numbers. Core inflation had slowed through the second half of last year, and in December Fed officials pencilled in three quarter-point cuts for 2024. Futures traders went further, pricing far more easing than that and, for much of January, treating March as the likely starting date. Jerome Powell pushed back at the end of the month, saying a March move was unlikely, but the market still hoped for a first cut by May.

Spring cuts priced out

The report showed how flimsy the bets on quick Fed easing had been. Shelter costs remain sticky and transport services prices are rising faster, which put a bump in the road for disinflation. The two-year yield, the one most sensitive to expected policy, had to shed the bets on spring cuts. The Fed will not ease until core prices slow decisively from month to month.

The report landed on a market already leaning the wrong way. The strong January jobs report earlier this month, with 353,000 new positions and a jump in hourly earnings, had forced traders to push back their expected first cut once. The inflation figures forced a second retreat within ten days. When expectations have to be revised twice in quick succession, positions built on the old view are unwound in a hurry, which is why the move in two-year yields was sharper than the size of the surprise alone might suggest.

Where the heat came from

Shelter makes up about a third of the headline basket, and it is measured in a way that lags the market. The official index tracks rents paid by sitting tenants and the imputed rent that homeowners would charge themselves, both of which adjust slowly as leases roll over. Rents on new leases cooled sharply last year, so the index should follow in time. A jump in owners' equivalent rent in January showed that the catch-up can stall for a month or two.

Transport services tell a less comforting story. Car insurance premiums have been rising at a double-digit annual pace, as insurers pass on the higher cost of repairing and replacing vehicles. Repair bills reflect wages and parts prices, and those do not reverse quickly. A 0.4 per cent monthly rise in core prices works out at close to 5 per cent annualised, more than double the Fed's 2 per cent target.

The echo of last January

Traders had a recent reminder of how January can mislead. A year ago the January consumer-price report also came in hot, alongside strong hiring, and markets that had been pricing cuts in 2023 abandoned them. The Fed went on to raise rates three more times, in March, May and July. The circumstances today are different, since core inflation has fallen much further and the Fed has signalled that its next move is a cut. The lesson is narrower: a single month can reset the timing of policy even when it does not change the direction.

Who pays for a later cut

The repricing runs through every market tied to the policy rate. The Fed has held its target range at 5.25 to 5.5 per cent since July, a 22-year high, and each month without a cut keeps it there. Holders of money-market funds and Treasury bills keep collecting yields above 5 per cent, so the incentive to move cash into longer bonds weakens. Companies and households on floating-rate debt, from leveraged-loan borrowers to credit-card holders, keep paying those rates for longer.

The dollar tends to firm when American short-term yields rise relative to those abroad, which tightens conditions for emerging-market borrowers with dollar debts. Mortgage rates follow the ten-year yield rather than the two-year, but a higher path for the funds rate lifts the whole curve. Housebuilders and small firms, which lean hardest on credit, bear most of the cost.

The stockmarket drew the same distinction on the day. Small-company shares, whose issuers rely more on bank loans and floating-rate debt, fell much harder than the large technology companies that dominate the main indices and sit on large cash piles. Regional banks, already under pressure after New York Community Bancorp's losses on property loans, lost ground too, since a longer wait for cuts means a longer wait for relief on their funding costs and their commercial-property borrowers.

The case for patience

There is a fair argument that January flatters inflation. Many firms reset prices at the start of the year, and seasonal adjustment does not always strip the effect out, so the month has a history of running hot. The Fed's preferred gauge is also the personal consumption expenditures index, which gives shelter a smaller weight and usually runs below the consumer price index. A cooler reading on that measure could soften the blow.

That argument explains one month and falls short of justifying a spring cut. The Fed said in January that it would not reduce rates until it had gained greater confidence that inflation was heading sustainably to 2 per cent. One hot print does not destroy that confidence, but it pushes back the date by which officials can claim to have it. February's inflation figures arrive in mid-March, shortly before the Fed's March meeting and its fresh projections, and those will show whether January was a blip or a trend.

January's hot figures ended any complacency about early cuts. Short-dated yields will probably stay high, and the first cut now looks likelier in the summer than in the spring, with floating-rate borrowers and small companies paying for the delay.