Soft PCE inflation keeps rate cut hopes alive, but markets stay cautious

Some festive joy for the markets as core PCE eases

As traders enter a quiet holiday week, there was relief on Friday after the Fed’s favourite inflation metric printed below expectations. Both the headline and core PCE price indices rose by just 0.1% month-on-month against projections for a 0.2% increase. For the latter, this was the lowest acceleration since May.

On an annual basis, core PCE was up by 2.8%, unchanged from the prior month, but the data nevertheless boosts hopes that inflation could still surprise to the downside in the coming months. Other components of the Personal Income and Outlays report were solid, with incomes and spending rising by 0.3% and 0.4% respectively, so the data doesn’t change a whole lot when it comes to the outlook for the US economy. But it does suggest that the Fed may have been too downbeat about the prospect of inflation moderating anytime soon.

Wall Street rebounds but caution keeps bulls in check

The Fed slashed its predictions of how many times it would cut rates in 2025 from four in September to just two 25-basis-point reductions in its December dot plot last week, triggering a selloff on Wall Street. Tech stocks tumbled the most, but a recovery is already underway, and the S&P 500 is still up a hefty 24% in the year-to-date.

With no Fed officials scheduled to speak over the next couple of weeks, markets will have to keep guessing whether the soft PCE inflation readings shifted policymakers’ views. Investors will also have to wait a bit longer than usual for the next jobs report as it’s not due till January 10 because of the holiday period.

This likely constrains the gains on Wall Street in the short term and with the market pricing of Fed rate cuts little changed after the data, investors don’t appear to be getting ahead of themselves this time with dovish bets.

Clouded outlook

US futures are climbing today, with relief about a last-minute deal by Congress on Friday to avert a US government shutdown helping to extend the rebound. But stocks elsewhere are mixed on Monday amid the many uncertainties hanging over the market.

The political instability in France and Germany, China’s tepid economic recovery and the likelihood of a new global tariff war under Trump 2.0 are all weighing on the outlook for 2025. The incoming Trump administration could also push for increasing the US debt ceiling or removing it altogether, and that’s another reason aside from the Fed’s hawkishness that’s keeping US Treasury yields elevated lately.

Yen on shaky ground

This in turn is supporting the US dollar, which has eased off from Friday’s lows today. It is edging higher against the yen after pulling back from five-month highs on Friday when it surged to just below the 158 level. The yen’s slide prompted fresh verbal intervention by Japan’s finance minister, Katsunobu Kato, who said the government is “alarmed” by the market moves and warned of “appropriate action”.

His comments have likely slowed the yen’s decline for now, but the thin liquidity during the Christmas and New Year lull could spark some unwarranted spikes, especially as there are some Japanese releases on the agenda this week, such as the Tokyo CPI and the Bank of Japan’s Summary of Opinions of its latest policy meeting.

In other FX pairs, the euro was struggling to hold onto the $1.04 handle, while the pound pared earlier losses when it slid on the back of a downward revision to UK GDP growth for Q3.