Higher-than-expected CPI data drives market selloff, especially for small caps
Wednesday's CPI report drove a selloff in the markets. The Nasdaq-100 ETF (chart below, blue line) and Nasdaq Mid-Caps ETF (orange line) both fell nearly 2% yesterday, and the Nasdaq Small-Caps ETF dropped 5.5% (green line).
The disappointing CPI report also pushed up rates, with 10-year Treasury yields rising 15bps to 4.3%, as markets pushed back expectations for the first Fed rate cut to June from May.
This helps explain the bigger selloff in small caps since they typically have more floating rate debt, making them more rate sensitive.
Core services and housing kept inflation higher
Why were markets so disappointed by this CPI report? Simply put, headline and core didn’t fall as much as expected.
Headline CPI inflation slowed to 3.1% YoY (chart below, orange line), but markets expected 2.9%. And core (which excludes food and energy) was unchanged at 3.9% YoY (chart below, orange line) against expectations it would fall to 3.7%.
The higher-than-expected result was mostly due to two categories: housing (purple area), which is still up 6% YoY, and core services ex housing (blue area) – which is back above 4% YoY. The report wasn’t all bad news, though. Core goods (red bars) and Energy (black bars) remain a drag on inflation.
Leading indicators suggest core services and housing inflation should keep slowing
So should we expect housing and core services to hold up inflation now? Fortunately, their leading indicators suggest this report might be a one-off, and they should keep slowing from here.
1. The 2.5-year low in Zillow’s new rent inflation points to slower housing inflation
Zillow’s new rent inflation remains in the downturn that began in early 2022, having plateaued at a 2.5-year low for the last six months (chart below, blue line). So, although housing inflation didn’t fall as much as expected this month (purple line), the lower new rents inflation will weigh on overall housing as they filter into the CPI sample.
2. The 3-year low in the quits rate indicates wage-driven core services inflation will slow further
Core services ex housing is mostly wage driven, so we look to the labor market. The quits rate acts as a leading indicator of wage growth because if fewer people are quitting, that means the labor market is loosening, which takes pressure off wage growth (chart below, blue line).
With the quits rate down to a three-year low (pink line), we should see wage growth and, in turn, core services ex housing inflation, slowing in the coming months.
Leading indicators of inflation suggest markets may have overreacted to January CPI
With the leading indicators for the key drivers of inflation pointing to further slowing still to come, it looks like markets may have overreacted to yesterday’s inflation data.
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