Wall Street remains suspicious of reflation after US CPI beats expectations

U.S. consumer prices posted their biggest increase since 2008 in May, yet details of data released on Thursday supported the Federal Reserve's view that the surge in inflation will prove short-lived.

As investors digested the data, the initial rise in Treasury yields lasted just over an hour before resuming recent losses by lunchtime. Technology stocks led the gains, with the Nasdaq 100 outperforming the broader market, while sectors more sensitive to the economy lagged.

“It’s not going to be enough to get the Fed to back off, but it’s the latter — the bigger picture — that matters,” said Ross Mayfield, investment strategist at Robert W. Baird & Co. “If the economy is strong, people are out shopping, sales are high and prices are rising because of demand, that’s good for stocks.”

The data offer little reason for confidence to either side of the inflation debate, but those most in need of a shot in the arm are the reflationists.

Bets on rising price pressures are now set to remain on the back foot. Market expectations for price increases are falling ahead of the data, with two-, five- and 10-year breakeven inflation measures all moving lower after peaking in mid-May.

"The market is pricing in an extremely comfortable scenario: low inflation and faster growth," said Pascal Blanque, chief investment officer at Amundi Asset Management. "But we may end up with structurally higher inflation and lower growth." He recommends shorting duration and going long on value stocks.

There are still plenty of reflation bets in the market. Investors continue to buy inflation-protected bond ETFs, and despite price volatility, the $29 billion iShares TIPS ETF (TIP) has seen inflows for six straight weeks.

Dennis DeBusschere and his Evercore ISI team see the recent slowdown in market inflation expectations as a tailwind for growth. The strategists say the odds of yields moving “significantly higher” are rising again as short positions in the bond market are swept away, the labor market improves and China weighs on commodity prices.

“The modest decline in inflation expectations gives the Fed room to maintain accommodative policy for longer given that the longer-term demand outlook remains firm,” they wrote in a report this week.

The inflation data initially pushed the 10-year Treasury yield up a modest 3 basis points, but by 14:45 New York time it had fallen 2 basis points to 1.462%. It has fallen 26 basis points since the end of March.

In the stock market, flows into ETFs tracking small and value stocks have slowed after peaking in March. The $45 billion Financial Select Sector SPDR Fund (XLF), whose assets tend to benefit from rising interest rates, saw its biggest withdrawal since April on Wednesday. Despite three days of strong inflows, the $70 billion iShares Russell 2000 ETF (IWM) still saw outflows overall in June.

“The reflation trade has done too well since the 10-year peaked on March 31, and sectors like financials are clearly telling a different story than bonds,” said Adam Phillips, managing director of portfolio strategy at EP Wealth Advisors in New York. “Given this divergence, I don’t think it’s surprising that the reflation trade is taking a breather here.”