Executive Summary
Headline CPI elevated at 2.7% YoY (core 3.1%), base effect adjustments suggest true inflation pressures are closer to 2.3–2.8%, which is aligned with the Fed’s target. However, producer prices tell a different story, with PPI components posting fresh twelve-month highs, mostly from tariff-driven cost pressures. Fed faces a dilemma in September FOMC meeting: CPI indicates stability, while PPI suggests inflationary risks remain.
Markets still assign high probability to a September rate cut, but expectations have cooled from 90% to 84% after the July PPI surprise. Treasury yields also confirm this uncertainty, with short-end pricing in three to four cuts over the next year, but the long end holding stubbornly high, driving a modest bull steepener. We believe the Fed will ultimately deliver at least 75 bps of cuts by mid-2026, but the path will be uneven, with trade policy shocks complicating inflation measurement.
CPI Base Effects Suggest More Benign Inflation
Headline CPI in July printed at 2.7% and core at 3.1%, but adjusting for base effects yields a softer picture: headline inflation at 2.33% and core at 2.78%, which is much closer to the Fed’s comfort zone.
In effect, the economy is not re-accelerating in price terms. Goods disinflation continues, with supply chains stable, while services inflation remains sticky but not worsening. The Fed is likely to view July CPI as transitory noise rather than a genuine resurgence in inflation.
PPI Points to Tariff Footprint
In contrast, producer prices are showing strain. Final demand ex-food and energy rose 0.6% MoM, the strongest in twelve months. Processed and unprocessed goods for intermediate demand also posted twelve-month highs, a clear reflection of tariff effects feeding into input costs.
Corporates are reporting material hits from tariffs: Deere disclosed Q3 tariff costs of $200m, with $600m expected for 2025. These costs are effectively a hidden tax, compressing margins and distorting effective tax rates. While some of the burden is passed on to consumers, corporates are absorbing a meaningful share, which will weigh on profits.
The Fed cannot ignore this divergence. CPI looks benign, but PPI reveals underlying pressures that may yet pass through. This explains why markets pared back cut expectations after the July release.
Labour Market
Long-term labour market movement is tied to demographics and AI. Companies are expected to operate with smaller workforces but higher output, reducing the number of entry-level roles while increasing pay for skilled workers as expertise becomes more valuable. These trends point to productivity gains that could ease inflation pressures over time, while also creating structural shifts in wages and employment that the Fed will need to consider in setting policy.
Yield Curve and Market Pricing
The US yield curve has re-steepened modestly. The 2-year trades near 4.0%, while the 30-year approaches 4.9%, restoring a positive 2s–30s slope of around 90 bps. Futures markets imply three to four cuts by end-2026, with Fed funds priced around 3.2%.
However, near-term probabilities have softened. CME FedWatch now assigns 84% chance of a 25 bps cut in September, with zero probability of a 50 bps move. Cuts beyond September remain conditional on incoming labour and inflation data, and particularly how tariffs continue to distort producer prices.
Housing and Real Yields
Mortgage rates have eased to 6.5%, sparking modest interest in homebuilders, many of which are up double-digits in the past three months. Real yields, however, have climbed in tandem with nominal yields, signalling that the market views current inflation spikes as transitory. This strengthens the case for the Fed to focus on growth rather than prices later in the year.
Bottom Line
We maintain a constructive stance on duration. While PPI complicates the inflation picture, CPI trends and real yield dynamics suggest the Fed will resume cutting by year-end. Our positioning favours:
- Long Fed fund future to capture deeper-than-priced Fed easing in 2026.
- Yield curve roll down in the long end, where term premium remains elevated. The slope remain steep, the strategy can be finance with a lower yield repo.
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