Bank of America: Core CPI sub-index performance will determine adjustments to rate cut expectations

For the US CPI in September, Bank of America predicts that the overall and core CPI will increase by 0.1% and 0.3% respectively on a month-on-month basis. On a year-on-year basis, Bank of America expects the overall CPI to decrease by 0.2 percentage points to 2.3%, while the core CPI will remain at 3.2%. Bank of America's expectation for the core CPI on a month-on-month basis is higher than the market consensus.

Similar to the previous month, Bank of America expects core inflation to be pressured upwards by airfare prices and out-of-home accommodation costs. Apart from these volatile items, rent will continue to be the main sticky source of inflation. Another item to closely monitor is the prices of used cars, as wholesale auction prices for cars have risen in recent months, which should be reflected in the prices of used cars in September.

Furthermore, based on Bank of America's forecast for the September CPI and assumptions about PCE components, it is currently expected that core PCE inflation will increase by 0.18% on a month-on-month basis. Although this will be a decent figure, Bank of America expects that this data will neither be weak enough to trigger a strong market reaction nor strong enough to change the widespread consensus of a 25 basis point rate cut in November.

The performance of CPI components will be an important factor in assessing the impact on Federal Reserve policy. If core PCE on a month-on-month basis reaches or exceeds 0.3%, it will indicate a more pronounced acceleration trend compared to previous months. Bank of America believes that core PCE must reach at least 0.3% on a month-on-month basis for the market to consider the possibility of keeping policy unchanged in November or cutting rates as equally likely.

How to judge whether the Federal Reserve will keep rates unchanged in November, or cut rates by 25 basis points or 50 basis points? Bank of America points out that the market is currently pricing in a 21 basis point rate cut for November, indicating that the market believes there is a 16% probability of the Federal Reserve keeping rates unchanged. The last time the Federal Reserve stopped cutting rates after a 50 basis point cut (excluding cutting rates to zero) was in November 2002. The situation was completely different back then. Even after the strong non-farm payroll report released last week, Federal Reserve officials still indicated a tendency for further rate cuts, so Bank of America believes that the Federal Reserve is unlikely to change its policy direction due to one month of inflation data.

When analyzing the potential range of rate cuts for the remainder of 2024, Bank of America points out that the impact on PCE components is crucial based on different possibilities of CPI performance. If core CPI reaches 0.3% as expected by Bank of America, but the increase is mainly concentrated in components of PCE with less impact (such as rent), the market's repricing for rate cuts will be smaller. As mentioned earlier, Bank of America believes that at least a 0.3% core PCE on a month-on-month basis is needed to shift the pricing for a rate cut in November to a half-and-half stance between staying put and cutting rates by 25 basis points. If the core PCE reading is very weak (possibly at 0.1% or below), the market may reconsider the possibility of a 50 basis point rate cut. In addition, tonight's CPI data will be a test of whether buyers are returning to the U.S. bond market after recent selling. The last time the 10-year U.S. Treasury yield exceeded 4% was in early August when the U.S. released an unexpectedly weak employment report. If the CPI report confirms the continued trend of slowing inflation, Bank of America expects a slight return of demand for U.S. bonds in the market, especially in the short and medium parts of the curve, as investors remain cautious about election risks and skeptical about the possibility of an economic "hard landing."

If the CPI data overturns the narrative of slowing inflation, it could lead to more long positions in U.S. bonds being liquidated in the market. Currently, CTAs (commodity trading advisors) still have room to reduce their historically long positions in 10-year Treasury futures contracts. A strong CPI reading may not only further eliminate rate cut expectations for short-term yields but also prompt the market to reassess the upper limit of neutral interest rates, triggering more parallel selling of yield curves.