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T Today's U.S. July CPI report may shift Fed rate-hike odds
Inflation expectations remain near 2-month high despite weak inflation statistics
North Korean tensions could worsen on upcoming joint U.S.-South Korean military exercises

Today's U.S. July CPI report may shift Fed rate-hike odds -- Today's July CPI report, along with the PCE deflator report in two weeks, will be important for the Fed's policy outlook and could shift market odds for a near-term Fed rate hike. The odds for a Fed rate hike by this December are currently at 52%, according to the federal funds futures market.

The Fed so far believes that the recent weakness in the inflation statistics is transitory and is due to special factors such as price declines in cell phone services and prescription drugs. However, some Fed members are concerned that the weakness might be more fundamental and they favor a delay in the next rate hike until it becomes clear whether inflation will in fact rise to the Fed's +2.0% target over the medium term. St. Louis Fed President James Bullard (non-voter), for example, said on Aug 2 that "Given the inflation outlook, which has deteriorated in 2017, I would not support further moves in the near term. It's possible the data will turn around, but we'll have to see. I think for now we should remain on pause."

The recent drop in the inflation statistics has been pronounced for the CPI and the PCE deflator. Specifically, the CPI has fallen sharply by -0.9 points to a 9-month low of +1.6% and the core CPI has fallen by -0.6 points to a 2-1/2 year low of +1.7% y/y. Meanwhile, the PCE deflator, the Fed's preferred inflation measure, has fallen by -0.8 points to a 10-month low of +1.4% y/y and the core PCE deflator has fallen by -0.4 points to a 1-1/2 year low of +1.5% y/y.

The market consensus is for today's July CPI report to rise to +1.8% y/y from June's +1.6%, but for the July core CPI to be unchanged from June's +1.7% y/y. An uptick in the headline CPI would not be surprising given the 15% rally in crude oil prices seen in the past seven weeks.

Thursday's July PPI report was softer than expected. The July final-demand PPI fell to +1.9% y/y from June's +2.0% and the July core PPI fell to +1.8% y/y from June's +1.9%.

Inflation expectations remain near 2-month high despite weak inflation statistics -- The weakness in the inflation statistics seen since March, along with the downtrend in crude oil prices seen during March-June, were the main factors pushing inflation expectations lower through mid-June. The 10-year breakeven inflation expectations rate fell from the 2.00% level in mid-March to a 10-month low of 1.66% in mid-June.

However, inflation expectations in the past two months have been on the rise, mainly because of the sharp 15% recovery rally in crude oil prices. Specifically, the 10-year breakeven inflation expectations rate since mid-June has risen by a total of +15 bp to 1.81%. The 2-month rise in the 10-year breakeven rate has been a bearish factor for T-note prices, although T-note prices this week have rallied on the North Korean tensions.

The consensus is for the U.S. inflation outlook to remain tame over the near-term, which should provide underlying support for T-note prices. However, if the U.S. inflation statistics should start to climb, and if crude oil prices extend the June-Aug rally, then T-note prices will obviously suffer.

North Korean tensions could worsen on upcoming joint U.S.-South Korean military exercises -- Volatility on Thursday rose further and stocks fell sharply after President Trump doubled down on his "fire and fury" warning to North Korea on Tuesday. Mr. Trump on Thursday said that maybe his "fire and fury" warning on Tuesday wasn't "tough enough." He added that if North Korea "does anything" to the U.S. or a U.S. ally "things will happen to them like they never thought possible." Mr. Trump's warning on Thursday came after North Korea outlined a plan for test firing four missiles towards the waters near Guam that would pass over Japan.

The markets are taking the exchange of threats much more seriously with the S&P 500 on Thursday falling to a new 1-month low and closing sharply lower by -1.45%. The IShares MSCI South Korean ETF (EWY) on Thursday plunged by another -2.46% to post a new 3-month low. The South Korean ETF has now corrected lower by a total of -8.4% from the 10-year high posted just a few weeks ago on July 24.

Dec gold on Thursday rallied to a new 2-month high and closed up +0.94% on safe-haven demand, adding to Wednesday's +1.32% rally. However, commodity prices in general fell on risk-off selling with the Thomson Reuters Equal Weight Commodity Index (CCI) falling by -1.27%.

The S&P 500 VIX index on Thursday spiked up to a 3-month high of 16.04% from 9.93% as recently as Monday. The T-note TYVIX on Thursday rose to a 1-month high of 4.56%, up from 3.84% on Monday.

The situation between the U.S. and North Korea is likely to remain tense in coming weeks, particularly if North Korea makes good on its threat to fire missiles over Japan into the waters close to Guam. In addition, North Korea is likely to be particularly paranoid this year as the annual joint U.S.-South Korean military exercises are scheduled to begin on Aug 21 and last about two weeks. The exercises usually involve tens of thousands of U.S. and South Korea troops. Last year, North Korea conducted its fifth nuclear test a week after the U.S.-South Korean military exercises ended.

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