Next big shoe to drop in financial markets: Inflation that fails to respond to Fed rate hikes

Traders, investors and strategists are adding another factor to the list of reasons why financial markets may be more volatile for at least the next three to four months: the likelihood that Fed rate hikes won’t affect inflation by then . .

Wednesday’s price action reflected the continuing anxiety of the stock market, with the three main indices with strong losses. The Dow Jones Industrial Average DJIA,
down more than 1,000 points during the afternoon, while the S&P 500 SPX,
more than 3% fell amid a runaway to government bond security as investors reassessed Fed Chairman Jerome Powell’s comments on Tuesday and his reassurance there were plausible paths to a “soft” landing.

Reads: Why are stocks falling? The fragile rebound in the “bear market” underscores investor concern

Shares had already been hit in the past two weeks since the Fed’s May 4 decision to offer a 50 basis point hike, its biggest rate hike in 22 years. One day after the Fed’s move, Dow’s industrial sectors fell nearly 1,100 points and, along with the Nasdaq Composite Index COMP,
noted its worst daily percentage drop since 2020 due to signs of panic sales on Wall Street. This year’s stock sale has left the top three indices with double-digit losses.

What has yet to be fully considered in the financial markets is the idea that US inflation, at 8.3% in April, but still close to a maximum of four decades, may not respond to the rises. Fed rates this summer, according to traders and strategists. and investors. Interest rate hikes typically take six to nine months, and even two years, for the economy. But this political backlog can be lost in markets accustomed to years of easy money and increasingly unsettling. While the Fed’s effort to cut its balance sheet by nearly $ 9 trillion adds an extra layer of hardening to financial conditions, it doesn’t begin until June 1.

“The significant impact of rate hikes is likely to be felt later this year,” said David Petrosinelli, a senior trader at InspereX in New York, who has subscribed to more than $ 670 billion in securities. Meanwhile, the Fed is “losing space,” or public confidence, “very quickly because there’s really no light at the end of the tunnel about inflation.”

“We are at the first or second entry of market volatility because it is not just what the Fed is doing, it is what the Fed is not doing,” he said by telephone, referring to the decision of policymakers not to start. to reduce your portfolio. until next month. “There is a growing skepticism about Powell and the Fed’s current game plan. The window or aisle for a soft landing is narrowing every day, and there is a growing scenario where inflation is not declining significantly over the next few years. months of Fed rises “.

As of Wednesday, traders in derivative-like instruments known as bindings were fixing prices at five annual general inflation rates in excess of 8%, according to consumer price index reports from May to September. This is due in large part to rising energy costs and reflects a marked change from expectations on 6 May, when traders forecast that inflation would begin to fall below 8% in June.


The table above reflects the projected gain in the annual global CPI rate over the previous year. Five-month readings of more than 8% are now set, although Powell reiterated Tuesday that half-percentage-point interest rate hikes at both the June and July Fed meetings remain the case. reference.

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


Speaking at a Wall Street Journal event on Tuesday, Powell sought to reassure the public that there are “plausible paths” to a “soft” landing for the economy, even if there has been some “pain.” ” ahead. If necessary, he said, the Fed would not hesitate to push rates beyond “widely understood levels of neutrality,” or a level at which policy does not drive or slow economic growth, to reduce inflation. Powell said the Fed would continue to raise rates until there was “clear and convincing evidence” that inflation was falling. Currently, the Fed fund rate target is between 0.75% and 1%.

Right now, financial markets have four different minds when it comes to inflation, said Jim Vogel, FHN Financial’s interest rate strategist in Memphis.

The bond market “is leaning toward the Fed’s idea of ​​success, though it’s not sure at the moment.” The stock market “almost wants the Fed to fail” because of the idea that higher inflation may help some stocks perform better, Vogel said in a telephone interview. “Commodities are confusing” and the futures market “is divided between a Fed that can be successful, but not for an extended period of time.”

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

These dynamics “accelerate short-term inflation, although inflation could resolve on its own in the long run,” Vogel told MarketWatch. Meanwhile, “there is more room to run in the sale of shares, as investors punish stocks with international exposure, and financial markets will be prone to episodes of illiquidity and mild panic.”

Regardless of which inflation result is correct, according to Vogel, the Treasury curve will continue to flatten with some differentials, such as the one between 3- TMUBMUSD03Y,
and 10-year rates TMUBMUSD10Y,
potentially invest between 20 and 30 basis points at some point.

Depending on how global geopolitical conditions unfold this fall, “we could be looking at an environment that will easily last until 2023, with Fed policy dormant during the first half of 2024.”

Reads: Wild changes in equities and bonds offer the taste for more volatility due to the risk that US inflation continues to rise

InspereX’s Petrosinelli sees the possibility that the 10-year rate could move to around 4%, from Wednesday’s level to around 2.9% in the second or third quarter, takes a bite out of tech stocks, while the Treasury curve reverses. As of the afternoon’s trading, Treasury yields were generally lower as investors turned to government bonds, reducing the 2- to 10-year rate differential to 23 basis points in a worrying signal about the prospects.

Walgreens Boots Alliance Inc. WBA,
Coca-Cola Co. KO,
and Walmart Inc. WMT,
were among the Dow’s biggest losers, while the shares of retailer Target Corp. TGT,
it fell more than 25% on Wednesday after reporting a sharp loss in earnings amid deepening widespread pessimism in the markets.

“We’re a little more optimistic about the peak of the fall in the fall and we don’t see any recession in the United States,” said Jay Hatfield, chief investment officer of Infrastructure Capital Advisors in New York, a publicly traded fund manager. and hedge fund that oversees about $ 1.18 billion in assets. He sees that the remaining 10 years remain around 3% and that stocks remain limited.

But in a non-core scenario where markets suspect that the Fed is ineffective, which puts it at between 20% and 30% chance of reaching success, the 10-year rate could rise to 3.5% or 4%. and “our estimate of the fair value of the S&P 500 SPX,
will drop to 3,500 “on Wednesday from its current level near 3,935, Hatfield said by telephone.

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