This year, the ongoing battle between bulls and bears over the economy and markets has reached new heights. Recently, the bulls gained significant ground after the May Consumer Price Index (CPI) report revealed lower-than-expected inflation, prompting a surge in stock prices and a drop in bond yields. This development indicates that the Fed may soon begin cutting rates, potentially leading to a prolonged bull market.

Since the start of the year, two opposing economic outlooks have clashed. The bears have warned of persistent inflation, potential stagflation, and a hard economic landing, predicting more rate hikes and a market downturn. In contrast, the bulls have maintained faith in a disinflationary trend, anticipated a soft economic landing, and expected a rate-cut cycle, forecasting a continuing bull market. The recent CPI report for May gave the bulls a decisive upper hand, with the core rate rising only 0.2%—the smallest increase since August 2021—and the supercore services index declining for the first time in three years.

Stocks soared, led by the Russell 2000 small-cap index, and bond yields plummeted on the news. This market reaction underscored the prevailing disinflationary trend, contrary to the bears’ assertions. The Federal Reserve’s decision to keep short-term interest rates unchanged at its recent meeting, along with a reduction in expected rate cuts from three to one by year-end, added complexity to the outlook. Some interpreted this as a hawkish shift, but it may simply be an attempt by the Fed to temper soaring stock prices and falling bond yields, which could loosen financial conditions prematurely.

Despite the Fed’s updated projections, the markets seem to believe that rate cuts are imminent. The 2-year Treasury yield’s decline to 4.76% signals expectations of at least two rate cuts by year-end. As incoming economic data continues to support a disinflationary trend, this yield is likely to fall further, potentially boosting stock prices.

Interestingly, the Fed’s latest Summary of Economic Projections (SEP) suggests no further improvement in inflation for the rest of the year, despite the positive surprise from the May CPI report. The core Personal Consumption Expenditures (PCE) price index is expected to remain at 2.8%—its current level—which is puzzling given the recent favorable inflation data. Markets, however, seem to be looking past the Fed’s rhetoric and focusing on the broader economic trends.

The bears argue that the recent positive inflation data are outliers and that a recession and market decline are inevitable. However, this view appears as misguided now as it did six, 12, and 18 months ago. The ongoing disinflationary trend and the likelihood of rate cuts support a more optimistic outlook for the bull market.

In a recent analysis, it was noted that the May CPI’s 0% monthly increase shifted expectations for rate cuts to September. The year-over-year inflation rate fell to a new cycle low of 3.3%, with the core rate rising just 0.2%. This trend is reassuring for Fed officials and investors alike. However, the Bureau of Labor Statistics’ outdated shelter cost data, showing a 5.4% increase, skews the overall inflation picture. Real-time data from Rent.Research indicates a much lower annual increase of 0.77%, suggesting that the CPI would already be at the Fed’s 2% target if accurate data were used.

This discrepancy explains the significant drop in bond yields, with the 2-year Treasury yield falling to 4.70%. This yield, a key indicator of where investors see the Fed’s benchmark rate heading, reflects expectations of more than two quarter-point rate cuts. With the possibility of three rate cuts starting in September, market dynamics could shift significantly.

Fed Chairman Powell is unlikely to signal multiple rate cuts in the immediate term to avoid fueling a rally in risk assets, which could undermine efforts to control inflation. However, incoming data may reinforce the positive inflation trends observed in the May CPI report, supporting further rate cuts. Investors should continue to monitor the 2-year yield, which has been a reliable indicator of market movements and is likely to drive higher stock prices as it declines.

In conclusion, the battle between bulls and bears continues, but recent data and market responses suggest a favorable outlook for the bulls. As the Fed navigates its policy decisions, the disinflationary trend and potential rate cuts could sustain the bull market well into the future.