The ISM sends an ominous inflation warning shot across the bow

Markets

Following a robust first quarter for risk assets, market bulls were poised to maintain their dominance entering the second quarter buoyed by positive data from China and optimism surrounding the Federal Reserve's preferred price gauge, released late last week. This gauge was perceived, rightly or wrongly, as sufficient to allay concerns about inflation despite recent Consumer Price Index (CPI) overshoots.

However, the latest data from the United States, the world's largest economy, revealed a significant development. The ISM Manufacturing Purchasing Managers' Index (PMI) moved into expansion territory for the first time since late 2022, surpassing expectations with a reading of 50.3. Economists had anticipated a reading of 48.3, which would have marked the 17th consecutive contraction—however, an inflation warning shot across the market's bow came alongside this positive news.

While the upturn in demand and activity is encouraging, it has been accompanied by a strengthening of pricing power, with average selling prices charged by producers rising at the fastest rate in 11 months in March. This rise in prices is particularly notable in the consumer goods sector, as flagged by S&P Global’s in-house economist. This development contrasts with the positive tone of Friday's Personal Consumption Expenditures (PCE) data and underscores the challenges ahead in bringing inflation down to the Federal Reserve's 2% target.

While there's good news that the US manufacturing recession is over, unfortunately, it comes with a gnarly inflation kicker.

With the Fed constantly reminding us they are not on rate cut autopilot, it's safe to assume that the "good news is bad news" trade has heralded in Q2.

Still, it's important not to overanalyze holiday-thinned price action on the first day of a new month and quarter. However, it's worth noting the movement in US rates.

US yields saw a significant increase across the curve into the US afternoon, reflecting the implications of a surprisingly strong update on America's key manufacturing activity gauge, which entered expansion territory for the first time since September 2022.

While we maintain the perspective that the Fed is looking for an excuse and is eager to implement rate cuts, it's important to note that the market decided the front end of the yield curve based on policy speculation. So Even though the median dot plot marker for 2024 remained unchanged in March's dot plot redo, indicating an expectation of three rate reductions, the market-implied probability of the first cut occurring in June dropped below 50% gamblers chance at one point on Monday.

Hence, the US dollar rallied on increasing bets that the Fed will be late to the Central Bank rate cut party in June.

Meanwhile, pricing for the full year eased to a mere 66 basis points, almost equivalent to "half a cut" less than the 2024 median dot.

However, it would require a series of upside economic surprises to shift market pricing significantly towards the hawkish side of the Fed calculus. These surprises would likely need to stem from inflation or wage data overshoots. Absent such developments, the market may settle down, believing we are dealing with a relatively dovish Fed in an economy aiming to run at warmer temperatures than when the Fed typically cuts.

Stocks reacted negatively on Monday. It's worth noting that when it comes to the relationship between rate hikes and equities, the speed of the increase in bond yields often matters more than the specific level. A 10-basis-point rise in 10-year yields prompted some unease among stocks, which had been riding high on the momentum from Q1 and the Easter Egg sugar rush festivities.

Oil markets

Oil prices surged to a five-month high as the recent ISM data signalled the end of the prolonged US manufacturing recession, which is seen as bullish for oil demand. Throughout the session, oil futures fluctuated between gains and losses, with extended production cuts by OPEC+ through the second quarter providing support despite uncertain demand growth.

Indeed, optimism for economic growth was bolstered by manufacturing reports from the world's two largest economies at the start of April, providing further support for oil prices. In the United States, manufacturing expanded for the first time since September 2022, putting an end to a 16-month period of contraction.