Financial markets are running again with a “peak inflation” narrative. Here’s why it’s complicated.

Financial markets seized on Tuesday’s report of weaker-than-expected U.S. producer prices and followed it, driven by the underlying narrative that inflation may have peaked and is only likely to ease. mitigate further from here.

Investors and traders can hardly be blamed for cheering Tuesday’s developments given the euphoria that accompanied last Thursday’s weaker-than-expected consumer price index gains, which lifted the Dow. Jones Industrial Average by 1,201.43 points in a single day. Following Tuesday’s PPI report, stocks ended the US session higher, led by a 1.5% gain in the Nasdaq Composite Index. Yield-starved investors again jumped on Treasuries and the ICE US Dollar Index DXY,
+0.26%
fell 0.3%. And oil futures hit their lowest prices in three weeks before stabilizing higher as traders gauged demand prospects.

Here’s why assessing the most likely path of inflation is more complicated than it looks.

Of all the possible scenarios that could unfold, the one in which inflation falls but doesn’t head towards 2% quickly enough is perhaps the most underestimated risk in financial markets, according to fund managers and analysts. economists surveyed by MarketWatch. The end result would be that Federal Reserve officials could be forced to push interest rates even higher than most people currently imagine and hold them there for as long as needed, even if inflation shows signs of a smooth slowdown, they said.

Lily: Fund managers massively forecast stagflation next year with no one anticipating the Goldilocks scenario

October’s data is a “good” start, but “if financial conditions ease and consumer spending stays strong because people think the inflation problem is over, we’re just going to get back to where we were.” were” with aggressive rate hikes, said Eric Sterner, chief investment officer at Apollon Wealth Management, which manages $2.5 billion and is based in Mount Pleasant, South Carolina. “We’re going to be subject to restrictive interest rate levels for a while, and if we get a year of around 7% inflation – I don’t think we will, but if we do – that would be enough to put a 6% federal funds rate on the table.

“I always advise our individual clients to maintain a risk-free approach to their portfolios and always be invested in the market, but to focus more on quality stocks like utilities and healthcare and stay on the safe side. away from tech or small-cap names without a strong earnings history,” Sterner said by phone Tuesday.

Stock market today:
Live coverage of Tuesday’s market action

Investors cheered the latest sign of easing price pressures in October’s producer price index, which rose just 0.2%, sending all three major U.S. stock indexes higher for the day – although Dow Industrials DJIA,
+0.59%
were briefly shaken by reports of Russian missiles landing in NATO member Poland in the New York afternoon.

Less than a week ago, the Dow DJIA,
+0.59%
posted a gain of 1,201.43 points and its best single-day performance in more than two years after a weaker-than-expected Consumer Price Index report produced an annual headline inflation rate by 7.7%. It was the first reading below 8% in eight months for the annual headline rate, which may impact household expectations even as policymakers favor other price indicators.

By nature, financial markets are more focused on the next big event than on the nuances of the inflation debate, and the Federal Open Market Committee’s final meeting of the year on December 13-14 looms large. horizon. Fed funds traders are back to pricing with an 81% chance of a 50 basis point rate hike in December and just a 19% chance of another aggressive 75 basis point hike prevailing since June. Traders don’t yet see the likelihood of a 6% fed funds rate in 2023, though policymakers have another CPI and PPI report in their hands by their December meeting and may have need even more data to confirm where they will end up. go with the rates.

“The big question in my mind is whether (Fed Chairman Jerome) Powell is committed to getting inflation down to 2% or if he can slow down somewhere around 3%,” Sterner said of Apollo Wealth. Last week’s reaction to the October CPI data was “well overdone and anyone who jumps on it will be disappointed. In my eyes, this will be another bearish rally with a dead cat bounce.

The last time financial markets got hold of the peak inflation narrative was in August, after July’s CPI report and PPI report produced downside surprises. Since then, however, producer prices have started to rise again. And while the headline annual CPI rate has fallen, other elements of the September consumer price index point to lingering inflation and the October CPI is still not enough to move the index. ‘needle.

“The name of the game for much of this year is that there may be improvement, but not at a sufficient pace,” said Will Compernolle, senior economist for FHN in New York. “Inflation may continue to decline, but if it takes five years to hit 2%, the Fed won’t like it. Officials will have patience, but cannot wait forever. The result is that the Fed continues to climb and becomes more aggressive,” bringing the federal funds rate target closer to 6% from a current level between 3.75% and 4%, although it could consider a cut. 25 or 50 basis points at the end of the next year assuming inflation improves.

Since October, FHN has estimated that the final federal funds rate, or the level at which the Fed stops raising rates, should be 6%, Compernolle said by phone.

See also: A 6% federal funds rate? Some investors say the risk is there, raising the prospect of more painful Treasury selling

The difference between the narrative of peak inflation this time around and the one that unfolded over the summer is that inflation could indeed be showing further signs of moderating, analysts said. The problem is that it needs to fade quickly, not gradually, in order to really move the dial.

“Markets reflect human psychology and can be overtaken by the moment, and for the moment they will live and die by the data,” said Rob Daly, director of fixed income for Glenmede Investment Management in Philadelphia, which oversees 4 .5 billion dollars. “As we saw with the July data reading for the CPI, inflation did not moderate as quickly over the next few months and the blip was quickly corrected. So I’m hesitant to say that October readings for the CPI and PPI are a sign of something concrete. are tied to wages and stubborn to drive down.

Glenmede’s fixed income team has been on the sidelines ‘waiting for good entry points’, while holding cash and shorter duration bonds, and looking to buy longer duration debt at higher yields, Daly said by phone. The 60%/40% mix of stocks and bonds “had died before and is coming back, and having the fixed income safety valve is something we haven’t seen in a while, especially when yields are so much better.”

Still, “it’s premature to think that this encouraging month of data means everything is down” along with inflation, Daly said. “I’m not ready to say we’re off the hook. I want to slowly enter the market and come back to it. I think for the pockets of the market, it’s a good time to grow capital, but you have to be tactical and pragmatic to grow money. There is value there.