Next big shoe to drop in financial markets: Inflation not responding to Fed rate hikes

Traders, investors and strategists add one more factor to the list of reasons why financial markets could be more volatile over the next three to four months at least: the likelihood that Fed rate hikes will not not affect inflation by then.

Wednesday’s price action reflected the lingering anxiety gripping the stock market, with all three major indexes posting steep losses. The Dow Jones Industrial Average DJIA,
-1.05%
fell more than 1,000 points during the afternoon, while the S&P 500 SPX,
-1.63%
fell more than 3% amid a flight to safety from government bonds as investors reassessed Fed Chairman Jerome Powell’s hawkish comments on Tuesday and his assurance that there were plausible pathways towards a “soft” landing.

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Stocks had already been rocked in the past two weeks since the Fed’s May 4 decision to hike 50 basis points, its biggest rate hike in 22 years. A day after the Fed’s decision, Dow industrials fell nearly 1,100 points and, along with the Nasdaq Composite Index COMP,
-2.47%,
recorded its worst daily percentage decline since 2020 on signs of panic selling on Wall Street. This year’s sell-off in stocks has left all three major indices suffering double-digit losses.

What has yet to be fully priced into financial markets is the idea that US inflation, at 8.3% in April but still near a four-decade high, may not respond to Fed rate hikes this summer, according to traders, strategists and investors. Typically, it takes six to nine months, or even up to two years, for rate hikes to be felt in the economy. But that policy lag can be lost in markets accustomed to years of easy money and growing more worried by the day. Although the Fed’s efforts to reduce its balance sheet by nearly $9 trillion adds an additional layer of tightening in financial conditions, it does not begin until June 1.

“The significant impact of rate hikes will likely be felt towards the end of this year,” said David Petrosinelli, senior trader at InspereX in New York, which has underwritten more than $670 billion in securities. Meanwhile, the Fed is “losing room”, or public confidence, “pretty quickly because there really is no light at the end of the tunnel on inflation.”

“We’re in the first or second innings of market volatility because that’s not just what the Fed does, that’s what the Fed doesn’t do,” he said over the phone, referring to the policymakers’ decision not to start shrinking his portfolio until the next. month. “There is growing skepticism about Powell and the Fed’s current game plan. The window or corridor for a soft landing is narrowing day by day, and there is a growing scenario where inflation does not come down significantly over the next few months of Fed hikes.

On Wednesday, traders in derivative instruments known as fixings were pricing in five more annual inflation rates above 8%, based on May-September consumer price index reports. This is largely due to rising energy costs and reflects a notable change from expectations on May 6, when traders expected inflation to start falling below 8% in June.

Bloomberg


The table above reflects the projected gain in the overall annual CPI rate from the prior year period. Five months of readings over 8% are now underway, although Powell reiterated on Tuesday that interest rate hikes of half a percentage point at the June and July Fed meetings remained the case. reference.

Just two weeks ago, on May 6, traders were expecting inflation to fall below 8% earlier:

Bloomberg


In remarks at a Wall Street Journal event on Tuesday, Powell sought to reassure the public that there are “plausible pathways” to a “soft” landing for the economy, even if he may be “pain” ahead. If necessary, he said, the Fed would not hesitate to push rates past “broadly neutral levels” — or the level at which policy neither stimulates nor slows economic growth — to bring down the economy. ‘inflation. Powell said the Fed would continue to raise rates until there was “clear and convincing evidence” that inflation was falling. The target for the fed funds rate is currently between 0.75% and 1%.

For now, financial markets have four different views on inflation, said Jim Vogel, interest rate strategist at FHN Financial in Memphis.

The bond market is “leaning towards the idea that the Fed will succeed, even if the timing is uncertain”. The stock market is “almost wishing the Fed didn’t succeed” on the idea that higher inflation can help some stocks outperform, Vogel said in a phone interview. “Commodities are confused” and the inflation futures market “is torn between a Fed that can succeed, but not for an extended period.”

The problem, he says, is that even if Fed rate hikes reduce demand “at the margin,” policymakers “will be ineffective” in addressing the following factors: structural demand for workers; supply chain disruptions due to Russia’s war on Ukraine and China’s zero-tolerance policy on COVID-19; and the need for companies to redirect their “time, energy and money” towards the regionalization of some of their investments and operations.

These dynamics “accelerate inflation in the short term, although inflation may resolve itself in the longer term,” Vogel told MarketWatch. Meanwhile, “there is more room to run in selling stocks as investors punish equities with international exposure, and financial markets will be subject to bouts of illiquidity and mild panic.”

Regardless of the correct outcome for inflation, according to Vogel, the Treasury curve will continue to flatten — with gaps like the one between 3-TMUBMUSD03Y,
2.850%
and 10-year rate TMUBMUSD10Y,
2.939%
potentially reversing 20 to 30 basis points at any given time.

Depending on how global geopolitical conditions evolve this fall, “we could be looking at an environment that easily lasts into 2023, with Fed policy latent until the first half of 2024.”

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InspereX’s Petrosinelli sees a chance the 10-year rate could come closer to 4%, from Wednesday’s level around 2.9%, in the second or third quarter – taking a bite out of tech stocks – while the Treasury curve inverts again. In the afternoon session, Treasury yields were broadly lower as investors flocked to government bonds, narrowing the spread between 2- and 10-year rates to 23 basis points, a worrying signal for the outlook.

Walgreens Boots Alliance Inc. WBA,
-0.67%,
The Coca-Cola Co. KO,
-1.19%,
and Walmart Inc. WMT,
-1.72%
were among the biggest losers in the Dow Jones, while shares of retailer Target Corp. TGT,
+0.08%
plunged more than 25% on Wednesday after reporting a big profit loss amid deepening widespread pessimism in the markets.

“We’re a bit more optimistic about inflation peaking in the fall and not seeing any recession in the United States,” said Jay Hatfield, chief investment officer of Infrastructure Capital Advisors in New York, a traded fund manager. stock exchange and hedge fund that oversees approximately $1.18 billion in assets. He sees 10-years staying around 3% and equities staying within range.

But in an off-baseline scenario in which markets suspect the Fed of being ineffective — which he estimates 20-30% to materialize — the 10-year rate could climb as high as 3.5% or 4% and “our estimate of the fair value on the S&P 500 SPX,
-1.63%
would fall to 3,500″ from its current level near 3,935 on Wednesday, Hatfield said by phone.