Wait for rate cut gets longer after red hot US CPI data; action only in June or July, says this EM expert

The unexpected surge in US inflation has raised speculation surrounding the Federal Reserve's rate cut plans. With March rate cut prospects virtually non-existent, a rate action even in May looks highly unlikely following the latest CPI data. The US equity rally, which saw the S&P 500 scaling a record level of 5,000, has been fuelled partly by rate cut expectations. The question is: has the market fully factored in the potential for fewer rate cuts than earlier anticipated?

According to independent Emerging Markets commentator, Geoffery Dennis, there may still be some market exuberance to wane if only three rate cuts are on the horizon. In an interview with Moneycontrol Dennis says he expects the first rate cut to come by in the middle of the year. Edited Excerpts:

With US inflation data hotter than expected, is a rate cut in May now unlikely?

I've held the belief for some time that a rate cut wouldn't occur until June or July, especially with the economy unexpectedly performing well. The latest inflation report, while not disastrous, was notably stronger than anticipated across the board. This triggered significant profit-taking in the market and led to a shift in forecasts for the first rate cut. Now, it seems likely that the cut will happen around June or July, but this inflation report has certainly pushed the timeline further out.

The Fed's dot plot is anticipated during the March meeting. In December, the Fed had suggested a 75 basis point rate cut for the year, implying around three rate cuts. Is there a possibility that the Fed might reduce the expected rate cut to 50 basis points for the year, or is that scenario unlikely?

That's doubtful. I believe the Fed will likely maintain its projection of three rate cuts. In recent weeks, the market's expectation has shifted from anticipating five or six rate cuts to closer to three, which seems reasonable. While there is a slight risk of the scenario shifting to two rate cuts instead of four, I still think three is appropriate.

The concern with recent inflation reports is that headline inflation seems to be stabilising around 3 percent, which isn't ideal. Core inflation is gradually decreasing but remains just below 4 percent. A significant factor driving inflation is the persistently high service sector inflation, particularly in areas like housing and airfares. The Fed will likely need to see a reduction in service sector inflation before considering interest rate cuts.

Also Read: Everyone calm down about CPI

With the significant equity rally in the US and the S&P 500 surpassing the 5000 mark, is it possible that the market hasn't fully accounted for anything less than four rate cuts? Could there still be further pricing adjustments ahead for US equities?

I suspect it's pretty close to making that adjustment now, although it's hard to tell. Maybe there could be a little more froth left to dissipate if it becomes clear that only three rate cuts are likely. The inflation report was notably stronger than expected across the board. The significant sell-off in response suggests that the market has already begun to correct itself.

This adjustment could be viewed as profit-taking or a reduction in excessive market excitement. However, the fundamental narrative remains unchanged – interest rates are expected to decrease eventually, but perhaps later than initially anticipated. The economy will slow down a bit in 2024 but achieving lower inflation might prove more challenging than previously thought.

Do you think there's a chance that investors may turn risk off, given the reaction we have seen in the bond and currency market?

I anticipate we may witness further selling over the next few days or sporadically, although it might take some time to fully absorb this development. However, ultimately, I believe the dollar is currently overpriced. While it tends to rise during risk-off scenarios and concerns about the pace of US interest rate reductions, I foresee a downward trajectory for the dollar throughout the year.

Earlier, we saw the euro reach over 110 against the dollar; now it's around 107. So, while the movements aren't substantial, the strengthening of the dollar and the rise in bond yields above 4.3 percent could draw some funds back into the US, marginally affecting emerging markets negatively. Although emerging markets have not done badly thus far, these conditions aren't particularly favourable for them.

Despite this, I wouldn't adopt a negative stance entirely, as I believe the underlying narrative remains intact. While I wouldn't necessarily advocate buying immediately, I anticipate a return to a more positive market sentiment eventually. This shift should coincide with yields dropping back below 4 percent and a decline in the dollar. However, before that happens, we need to digest the impact of the recent concerning inflation figures.

Will India remain immune to global shocks? Will flows into India persist, especially in comparison to China, where there are hardly any signs of an economic rebound?

India has been an outperformer within the emerging market space, gaining around 2-3 percent in dollar terms while the broader emerging markets are down between 2-3 percent. The country continues to be the strongest growth story in the emerging market universe. However, you have to see earnings growth deliver to validate some of the valuations there. Challenges persist, but India remains broadly on track.

The decline of China in recent years has been very helpful for India. Even though a lot of the selling may be over in China, it's still going to take a lot to get foreign investors back. India seems to be their preferred choice compared to China. While oil prices have firmed up slightly, they remain within a trading range, which is favourable for India. Despite global uncertainties, India appears promising once the current global selloff subsides.

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