May Core Rises Less than Expected

MACRO FRAME

Global equity markets continue to remain focused on US-Iran peace negotiations and a potential reopening of the Strait. Core inflation offers a reassuring print that energy-linked inflation has yet to make its way into broader price pressures.

STOCK INDEX FUTURES

Equity index futures are lower but got a lift following May’s CPI report, which showed that core inflation rose only 0.2%, below expectations of 0.3% rise and a drop from April’s 0.4%. YoY, core stands at 2.9%. Headline inflation rose 0.5% to 4.2% YoY. Once again, energy prices were the dominant driver, accounting for over 60% of the monthly all items increase. For equity markets, the 0.2% core print is relatively constructive, as it treats the headline surge as a function of energy base effects rolling forward as a continued pass-through. The reading’s are unlikely to shift the FOMC’s calculus significantly. While core is relatively moving in the right direction, at 2.9% YoY remains well above the 2% target.

Tech remains under broad pressure after marking a sharp reversal in price action yesterday. Recent equity weakness has been driven largely by profit-taking and rotation out of crowded AI and semiconductor trades into value-oriented names, underscoring how narrow the market rally has been, with both the upside and recent sell-off disproportionately concentrated in AI-linked stocks. Since the War began on Feb 27th, the S&P 500 is up just under 7%, while the S&P 500 without AI stocks is effectively unchanged. Oracle will report quarterly earnings after the bell today, which markets will take to see how strong the legs are on the AI rally. While Friday’s selloff was the result of reduced AI spending fears in the economy, AI expenditures are likely to be little affected by a move higher in rates, which should continue to offer further tailwinds to the recent rally, despite the near-term weakness.

Watch point: Details regarding tanker traffic through the Strait will be a catalyst for global markets and may significantly reprice expectations over Fed policy, though negotiations are likely to need further time.

CURRENCIES

US DOLLAR: The USD index is down 0.10% to 99.81, feeling modest pressure from today’s core inflation reading. The geopolitical overhang remains over the dollar following the flare up in strikes between the US and Iran in recent days. Signs of a breakdown in negotiations and a resumption of fighting between the countries are likely to be dollar positive, with increased demand for dollar liquidity. However, news of progress on negotiations will pressure the dollar. While today’s inflation data saw a strong headline surge, the core print likely offers enough ammunition for policymakers at the Fed to delay a move upwards in rates, at least until underlying inflationary readings begin moving higher. Money markets are currently pricing a 65% chance of a hike before year end and are fully priced for a hike by January, virtually unchanged from yesterday.

Watch point: Demand for dollar liquidity remains heightened amid the flare up in hostilities, while May’s jobs report has provided the greenback with stronger support, potentially sustaining a break above into a higher range.

EURO: The euro is little changed at $1.1552 as attention centers around US-Iran developments and tomorrow’s European Central Bank’s policy decision. Markets have priced in a rate hike from the central bank for some time now, which should lead focus to the views of policymakers over second-round effects on inflation and whether or not that requires further policy tightening. Comments from policymakers that second-round effects are of major concern are likely to bolster the euro and reinforce expectations of additional rate hikes from the ECB this year.

However, a potential factor which could limit the need for additional policy tightening after June, would be that services inflation eased in the most recent data. Still, the ECB maintains the scope to tighten policy without worrying about impacts to economic growth, though the extent to which policy tightening is necessary may be limited to just one rate hike if the Strait is reopened within the month and if services inflation does not pick up. For the euro, broader risk sentiment will continue to determine price direction, while the interest rate differential against the dollar remains unfavorable given the recent shift in Fed expectations.

Watch point: While a June rate hike is expected from the ECB, a peace deal and restoration of oil flows through the Strait is likely to reduce tightening expectations.

BRITISH POUND: Sterling rose 0.13% to $1.3392. Aside from US-Iran developments, markets are looking ahead to UK GDP data on Friday. Recent PMI data has been revised upwards, which could reflect that the drop in sentiment over the economy may be overstated. Still, economic factors were a challenge ahead of the outbreak in hostilities between the US and Iran. Despite a dovish repricing of Bank of England expectations, the sterling has gained as a result of the reduction in geopolitical risk and decline in demand for the dollar. Money markets have priced a rate hike out to September, while a second rate hike is no longer expected in 2026.

JAPANESE YEN: The yen is little changed at 160.43 yen per dollar. Intervention risk remains front of mind for traders as the currency breaks the 160 level. With a June rate hike pretty much fully priced in, yen weakness is likely to persist even despite a move upwards. The BoJ may feel pressure to hike, but with policy rates still deeply negative in real terms, incremental moves are unlikely to deliver a durable yen rebound or materially change Japan’s still-fragile exit from deflation. Instead, markets are increasingly focused on the broader policy mix: rising long yields alongside a weak currency highlight concerns over Japan’s heavy debt load, while political support for a weaker yen, equity benefits from FX depreciation, and reluctance to tackle the debt overhang suggest any sustained yen strength will require more than rate hikes alone.

Any further depreciation in the yen is likely to be met with warnings from Japanese officials and raises the risk of official intervention. Traders are likely not willing to challenge official buying from the Bank of Japan or Japanese Treasury, though not excited to take up bullish positions either. Money markets continue to expect a rate hike come June, pricing a 85% chance of a hike. The market sees a total of 44 bps of tightening by year-end. Intervention risk continues to offer the currency support around the 160 level.

AUSTRALIAN DOLLAR: The Aussie is 0.14% lower at $0.7018 as the recent flare ups between the US and Iran kept traders of the risk-sensitive currency on edge. The NAB recently called off their expectation of another rate hike from the Reserve Bank of Australia, saying they expect a slowdown in the economy to limit price growth. Meanwhile, a mix of softer economic data has led markets to pare back expectations of another rise in the RBA’s policy rate. Still, demand is largely outpacing supply, labor conditions remain tight, leaving the inflation bias pointed upwards. The RBA has broadly signaled that it is in a wait-and-see mode following three rate hikes earlier this year and as a result markets are no longer any hikes by the end of the year. However, the trimmed mean measure of inflation sits at an annual pace of 3.4%, which is likely to reinforce a tightening bias from the RBA.

Watch point: While a durable end to the war would alleviate downside risks to growth and moderate inflation pressures, ongoing pass-through into broader prices is likely to keep the RBA on a tightening path.

TREASURY FUTURES

Yields are little changed across the curve, following today’s rather benign core inflation reading. Friday’s May nonfarm payrolls has removed labor market fragility from the Fed’s calculus, while today’s inflation data has reinforced a hawkish-leaning hold, but removed any immediate urgency to move rates higher. Markets price near-certainty on a June hold, but expectations of a hike later in the year remain unchanged from Friday. For now, price pressures have proven relatively transitory without presenting a durable second-round impulse. If core CPI prints above 3.0% annualized in coming readings, that argument becomes hard to sustain. The Treasury market has already begun pricing this scenario with the 2-year yield above 4.1% and the 10-year above 4.5%. Substantial curve flattening has been consistent with market sentiment repricing the front end for hikes rather than cuts.

Watch point: The path to tightening has become more evident though Wednesday’s inflation data offers relief for concerns of immediate policy tightening. Traders will look for evidence that price pressures have become more broad based as a gauge on policy expectations.

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