‘Peak inflation’ trade boosts financial markets as investors brace for US economic slowdown

Financial markets are increasingly trading on what Deutsche Bank describes as “a ‘peak inflation’ worldview” – one that would result in a less aggressive response from the Federal Reserve than previously feared. , although inflation has yet to show signs of a demonstrative peak.

The widely accepted view for now is that an impending economic slowdown and/or recession in the United States is likely to solve the problem of persistently high inflation over time. It’s just the latest way the usually optimistic and forward-looking markets are trying to focus on the bright side ahead of the Fed’s monetary policy meeting next Tuesday and Wednesday.

While an outright recession typically takes months to be declared by the only arbiter that matters, the National Bureau of Economic Research, traders and investors waste no time drawing their own conclusions. In a nutshell, they consider that an anticipated drop in growth in the world’s largest economy is equivalent to a drop in inflation at some point.

This thesis is reflected in break-even inflation rates trending between 2.18% and 2.6% on Friday, as well as a notable drop in yields on 5-, 10- and 30-year Treasury inflation-protected securities. over the past few days, according to data from Tradeweb. . In addition, most Treasury yields have fallen below 3%, while fed funds futures are trading at levels that imply Fed officials could forgo a 75 bp rate hike. basis in favor of a smaller 50 basis point move in September.

Meanwhile, inflation derivatives traders see the annual CPI rate falling to 2.5% next June from 9.1% in June.

“It’s hard to separate the idea of ​​a recession from the idea of ​​fixing inflation,” said Mark Heppenstall, chief investment officer of Penn Mutual Asset Management, which manages $31 billion from Horsham, Pennsylvania. “The thinking is that in a recession, inflation should roll over, although it’s unlikely to hit the Fed’s target anytime soon.

Last July, Heppenstall was one of the few people to openly say that the bond market may be underestimating the possibility of a prolonged period of higher inflation, one that has materialized. Now, he said, the Fed is unlikely to push its main policy rate target above 4%, from a current level between 1.5% and 1.75%, without “doing bring the economy down to a point where the Fed is doing too much.”

“The pandemic is creating lightning-fast displacement cycles, mini-cycles, and the idea is that the inflation cycle may be getting more severe, but short-lived,” Heppenstall said by phone. “So it’s safe to say that inflation is more likely to be persistent, but the market is saying the Fed won’t have to hike as much as previously feared, given the poor recent data.”

Much is based on the idea that inflation should eventually subside in the event of an economic downturn and return to a more normal-looking pre-COVID environment. But the past year has also proven how wrong so many people can be, and how it only takes a single shock – like Russia’s war in Ukraine – to upend common assumptions. If investors and traders get the path of inflation wrong again, the result will inevitably be additional volatility in the second half, similar to the brutal first half for stocks and government bonds.

A series of weak data cements the idea that the United States is heading for a slowdown, sending the three main stock indices DJIA,


decline in the afternoon and investors flock to the safety of government bonds. Data released on Friday showed worrying signs of deterioration in the economy, as evidenced by preliminary data from S&P Global’s Purchasing Managers’ Indexes.

And on Thursday, weekly jobless claims hit their highest level since November, the Philadelphia Fed’s manufacturing index unexpectedly fell deeper into negative territory, and the Conference Board said its main economic index shows that a US recession late this year and early next is now likely.

In a note on Friday, Deutsche Bank said “the market is increasingly trading a global view of ‘peak inflation’.” The final federal funds rate, or the level at which the Federal Reserve is considered to end its current cycle of rate hikes, fell below 3.5% from 4% to 4.25% ago. five weeks, said macro strategist Alan Ruskin.

Of the five scenarios he envisions, the one the market is most “flirting” with currently involves a “soft landing,” or no recession, and a terminal rate of 3% to 3.25%. Meanwhile, the market and the Fed are poised to “push back” against a second scenario in which inflation remains mildly tenacious, the US experiences a shallow recession, and the terminal rate moves between 4% and 4.25% . A third “outlier” scenario is one that involves a “rate-induced hard landing,” or deep recession, and a terminal rate above 5.5%.

Rather than viewing each scenario as “low-key,” the three possible outcomes “could represent stages in a longer tightening cycle and merge into a staggered bullish cycle that extends well beyond the current peak in the rate. funds in January,” Ruskin wrote.

According to Keith Lerner, Atlanta-based co-chief investment officer and chief market strategist for Truist Advisory Services, “the market is pricing in a high probability of a recession that could be mild, and that will contribute somewhat to inflation.”

“We are already seeing signs of some deflation signals in commodity prices and expectations,” Lerner said in a phone interview Friday.

However, there is one major factor that may still be missing in the current overall market thinking, and that is the historical inflation trend. In the 1960s and 1970s, “many underestimated the persistence of inflation over time,” said John Silvia, founder and managing director of Dynamic Economic Strategy in Captiva Island, Florida.

Now, “financial markets are again underestimating the persistence of inflation that is well above the Fed’s 2% target over a longer period,” said Silvia, the former chief economist at Wells Fargo Securities. , by telephone. “Therefore, the markets are betting on how seriously the Fed will pursue its inflation target, at the expense of its legacy. If we talk about bringing inflation down to 2% or 2.5%, that will not be resolved. by a simple and short recession.