Markets are pricing yesterday’s inflation

Financial markets received encouraging inflation data this week. US consumer prices declined in June, producer prices also fell, and underlying inflation showed signs of moderation.

Under normal conditions, this combination would strengthen expectations that monetary policy has reached its most restrictive point. Bond yields should decline, the US dollar should weaken, gold should benefit and equity valuations should receive additional support.

But these are not normal conditions.

The latest inflation figures describe an economy that benefited from falling energy prices during June. Markets, however, must now price a different environment; one in which geopolitical tensions are rising again, oil is trading close to $85 per barrel and important global energy routes remain exposed to disruption.

Investors may therefore be making a dangerous mistake: using yesterday’s energy prices to estimate tomorrow’s inflation.

The inflation data is better, but not yet safe

The US Consumer Price Index declined by 0.4% in June, its largest monthly decrease since April 2020. Core inflation was unchanged during the month and slowed to 2.6% annually.

These are significant improvements. However, much of the headline decline came from a 5.7% monthly fall in energy prices, including a 9.7% decrease in gasoline prices. Despite that monthly decline, energy prices remained 15.7% higher than a year earlier.

Producer prices delivered a similar message. The Producer Price Index fell by 0.3% in June, mainly because energy prices declined by 6.4%. Nevertheless, final-demand producer prices were still 5.5% higher than a year earlier, while the measure excluding food, energy and trade services increased by 5.1% annually.

The conclusion is important for traders: inflation is moderating, but the improvement remains heavily dependent on energy.

This means that the latest inflation reports should not automatically be interpreted as evidence that the inflation problem has been resolved. They may instead represent a temporary period of relief created by lower fuel prices.

If energy prices remain elevated in July and August, part of June’s progress could be reversed.

The US economy is not weak enough to force the Fed’s hand

At the same time, the US economy continues to demonstrate resilience.

Retail sales increased by only 0.2% in June, but the headline figure was reduced by lower gasoline-station receipts. Underlying consumer spending remained stronger, while May’s increase was revised upward to 1.0%. Retail and food-service sales were also 6.7% higher than a year earlier.

This combination creates a difficult environment for the Federal Reserve.

Inflation is not strong enough to make an immediate rate increase unavoidable. However, economic activity is not weak enough to justify rapid monetary easing either. The Federal Reserve is therefore likely to preserve maximum flexibility while monitoring energy prices, inflation expectations and consumer demand.

The current target range for the federal funds rate remains 3.50%–3.75%, following the Federal Reserve’s decision to leave policy unchanged in June.

For markets, the important question is no longer simply whether inflation is falling. It is whether inflation can continue falling while oil prices rise and consumer demand remains resilient.

That is a much more difficult question.

Oil has returned to the centre of monetary policy

Oil is no longer merely a commodity-market story. It has returned as a major macroeconomic variable.

Brent crude was trading around $85 per barrel on Thursday as renewed US-Iran hostilities increased concerns surrounding the Strait of Hormuz and the Bab al-Mandeb Strait—two critical routes for global energy transportation.

The direct impact of higher oil prices is visible through petrol, transport and energy costs. The indirect impact is potentially more important.

Higher energy prices affect production costs, shipping, aviation, agriculture, chemicals and consumer disposable income. Companies must either absorb these higher costs through lower profit margins or transfer them to consumers through higher prices.

Central banks cannot produce oil or reopen shipping routes. They can only respond to the inflationary consequences.

This is why geopolitical shocks can create an uncomfortable form of inflation: one that damages economic growth while simultaneously limiting the ability of central banks to reduce interest rates.

The bond market is sending a warning

The US Treasury market is already reflecting this uncertainty.

Despite softer inflation figures, the ten-year Treasury yield moved back towards 4.57%, while the two-year yield rose above 4.16%. The 30-year yield remained above 5%.

This is not the reaction investors would normally expect following a substantial monthly decline in consumer prices.

The message from the bond market is that one favourable inflation report is not enough to remove longer-term inflation, fiscal and energy risks.

For equity investors, this matters because higher long-term yields increase the discount rate applied to future corporate earnings. Companies with expensive valuations, distant expected profits or high refinancing requirements remain especially sensitive.

Falling inflation can support equities, but rising bond yields can remove much of that support.

Technology is priced for perfection

This sensitivity was visible in technology shares.

Semiconductor stocks declined sharply even after TSMC reported earnings growth of 77%. The Philadelphia Semiconductor Index fell by more than 4%, while the Nasdaq also moved lower.

When excellent corporate results are followed by falling share prices, investors should pay attention.

It suggests that expectations may already be extremely high. In such an environment, companies are not merely required to report strong earnings. They must exceed already optimistic assumptions and provide guidance capable of supporting elevated valuations.

The artificial-intelligence investment theme may remain structurally important, but structural importance does not eliminate valuation risk.

For traders, the distinction between a strong company and an attractive entry price is becoming increasingly important.

Why Gold can fall during a geopolitical crisis

Gold’s recent performance offers another important lesson.

Many investors assume that geopolitical instability must automatically push gold higher. However, gold declined towards $4,000 per ounce as oil prices, Treasury yields and expectations of tighter monetary policy increased.

Gold is influenced by two competing forces.

Geopolitical risk increases demand for defensive assets. But rising bond yields and a stronger dollar increase the opportunity cost of holding an asset that produces no interest income.

When a geopolitical crisis is interpreted primarily as an inflationary shock, yields may rise faster than safe-haven demand. Under those circumstances, gold can decline even while political and military risks increase.

This does not necessarily invalidate gold’s longer-term defensive role. It demonstrates that the timing of gold positions depends on real yields, dollar direction and monetary-policy expectations, not only on geopolitical headlines.

What traders and investors should monitor

The next major market direction is likely to be determined by the interaction of four variables.

• First, oil prices. A sustained move higher would challenge the recent improvement in inflation and increase pressure on energy-importing economies.
• Second, Treasury yields. If the ten-year yield remains close to or moves above 4.60%, expensive equity sectors may face additional valuation pressure.
• Third, the US dollar. The dollar remains close to a one-month low, but renewed safe-haven demand and higher US yields could support a recovery, particularly against currencies belonging to energy-importing economies.
• Fourth, market breadth. If major equity indices remain supported while semiconductor and other high-valuation sectors weaken, the headline indices may conceal a more meaningful deterioration beneath the surface.

Investors should therefore avoid treating every decline in inflation as an automatic signal to increase risk exposure.

The market must look forward

The latest US inflation reports are undoubtedly encouraging. They reduce the probability of an immediate monetary-policy response and demonstrate that price pressures can moderate when energy costs decline.

But markets do not trade the past. They discount the future.

June’s inflation data reflects June’s energy environment. The market must now assess July’s geopolitical environment, current oil prices and the possibility that future inflation reports may look less favourable.

The greatest risk is not that investors have misunderstood the latest data. It is that they may be giving too much importance to data that was already becoming outdated when it was published.

For traders and investors, the lesson is clear: softer inflation deserves attention, but it does not justify complacency.

The next significant market move will probably occur when oil prices, bond yields, the US dollar and economic growth begin pointing in the same direction.

Until then, volatility should not be dismissed as noise. It is evidence that the market is still trying to determine which inflation reality it should price.