What’s at stake for financial markets if investors get H2 inflation wrong again

Investors and traders trying to navigate one of the most dangerous times in financial markets in years are almost certain to face greater volatility in the second half of this year.

One of the main reasons is that few people seem prepared for the risk that US inflation, already at a nearly 41-year high of 8.6% in May, will stubbornly resist Federal Reserve rate hikes. It’s a dynamic that has played out time and time again in past periods of high inflation in the United States – in the 1970s under Fed Chairman Arthur Burns; the late 1970s during the short tenure of his successor, G. William Miller; and even in the 1980s under Paul Volcker.

Lily: History shows that inflation can take years to return to normal even when the Fed raises interest rates above 10%

In general, financial market participants increasingly expect inflationary pressures to subside. This is evident in fed funds futures trading now predicting that the central bank will hit the peak of its rate hike cycle around next March – when the Fed’s main policy rate target could range between 3.5% and 3.75% or more, from its current level of between 1.5% and 1.75% – before policymakers cut rates next year.

Expectations of slowing price gains can also be seen in the 5-, 10- and 30-year equilibrium rates trending below 3%, according to Tradeweb – levels that imply the Fed will eventually win its war on the Fed. inflation. And hope can even be found in the increased weight that investors are placing on a possible US recession – which, in itself, is supposed to calm inflation.

But in the corner of the financial market where traders can earn up to $1 million on a single trade by getting inflation right – the inflation derivatives market – the annual CPI rate is considered hot. for at least five more months: On Tuesday, fixing traders were expecting the annual CPI rate to hit 8.9% in June, 8.8% in July, nearly 9% in August, 8.9% in September and 8.1% in October. This is the case despite the possibility that the Fed could proceed with another 75 basis point hike next month, and policymakers remain in a politically vigilant position.

Fixing traders also don’t expect inflation to dip below 7.2% for the remainder of this year. This contrasts with the expectations of 54 economists in the Wall Street Journal’s June survey, which sees the annual CPI falling to just below 7% in December.

“The market has been looking for rallies to offset this year’s losses, and it’s fair to say it’s not ready for inflation that’s proving resilient to Fed rate hikes,” Rob said. Daly, director of fixed income for Glenmede Investment Management in Philadelphia, which oversees approximately $4.5 billion in fixed income assets. “I think we’re going to have a tough year for 2022. It’s going to continue to be a very volatile year, whether it’s rates or risk assets.”

“The question for the market is: ‘Will inflation go down and how much will it go down?’ If inflation is easing and appears to be stabilizing at lower levels, the market may get some traction,” Daly said by phone. “But you need to see rate of change dynamics over multiple time frames in order to feel more comfortable with putting money at risk.”

This year’s bond carnage has already put fixed-income exchange-traded funds on pace to post their worst first half on record, according to Dow Jones Market Data, and Daly says it’s possible to see further losses in the second half as investors weigh the growth outlook for the economy. Meanwhile, the US stock market fell into a bear market earlier this month and the three major indices DJIA,
-1.56%

COMP,
-2.98%

SPX,
-2.01%
gave up early early gains on Tuesday after a weaker-than-expected consumer confidence report.

Renowned economists like Treasury Secretary Janet Yellen aren’t the only ones to admit they got inflation wrong. The same goes for ARK Invest CEO Cathie Wood, who told CNBC on Tuesday that she had dramatically underestimated the seriousness of inflation and that the United States was likely already in a recession.

Nevertheless, Jay Hatfield, Managing Director of Infrastructure Capital Advisors, and Steve Englander, Head of G-10 Global Currency Research and North American Macro Strategy at Standard Chartered Bank, are among those who believe that inflation could peak in the second half of the year. and slow in the coming months.

Already, “demand is slowing, wages are lagging and demand for oil is going to fall – all of this has implications for prices,” Englander said by phone. Even though the annual readings continue to hover near 9% for some time, it’s the month-to-month changes and the baseline readings excluding food and energy that matter most in his mind. However, he said, “if we are wrong, it means the market is undervalued for such a scenario.”

Meanwhile, Hatfield points to falling commodity prices ranging from grains to aluminum and steel as reasons to believe inflationary pressures may ease in July data, to be released in August. . Although higher housing costs are “stickier” and may support a more pessimistic view of inflation, he said the biggest risk to financial markets is not inflation continuing to rise. , but the odds that the Fed is making a policy mistake by raising rates too much. He expects the Fed to suspend its rate hike campaign at the end of the year, when the fed funds rate target is around 3%, before cutting interest rates in 2023. because “Europe is likely to enter a deep recession and the rest of the world will crack before the United States,” he said.

The problem remains, however, if inflation comes down, but not enough. “It’s not the absolute level of inflation that matters most here, but the stickiness. This is where the rubber meets the road,” said investment manager Neil Azous of Rareview Capital in Las Vegas. “I think inflation will stay elevated for longer, above 5%, and the Fed will have to respond to that. Inflation will remain the predominant factor, not weaker growth and recession risk. When the inflation remains elevated for an extended period, it becomes more anchored in long-term expectations, the outcome the Fed fears most.

Continued inflation readings of around 9% would theoretically mean that the terminal interest rate, or the level at which interest rates end, “will be above 4% and potentially on the way to 5%,” Azous said. by telephone. Still, he says, the “truth will likely lie somewhere in the middle” of the outlook expressed by fixation traders and the expectations of economists.