Recent attacks on merchant shipping in the Red Sea are reviving broader concerns about a further outbreak of inflation, particularly in Europe, and could threaten to undermine the financial market's main narrative for the new year.
The narrative that gained momentum last week with the Federal Reserve's dovish stance and continued Tuesday is the idea that inflation will likely continue to ease enough to trigger a round of rate cuts in 2024. Financial markets are positioned for this flawless disinflation scenario to play out in several ways: Treasury yields mostly fell, traders stuck to expectations of up to five to seven quarter-point interest rate cuts next year in the U.S., and stocks rose into the New York afternoon and exited the S&P 500 SPX is close to breaking a record.
Developments in the Red Sea, which led the U.S. to announce a new international effort late Monday to prevent the attacks, sent oil prices CL.1, +1.53% CLG24, +2.02% higher for a second day, as shipping companies diverted their cargoes. Investors were also reminded of how reliant the world is on what Deutsche Bank strategists have described as a series of invisible networks across seas, air and land.
Read: Deutsche Bank warned months ago that shipping was one of the weakest links in the economy. Here is the must-see table.
“The Red Sea events overall have a greater impact on Europe than on the United States, which is somewhat isolated and more self-sufficient and produces its own energy.” But if they last long enough, over a period of three to six months, they could “It would affect the U.S. and it would have a ripple effect on other things,” said Derek Tang, an economist at Monetary Policy Analytics in Washington.
As BMO Capital Markets strategists Ian Lyngen and Ben Jeffery put it, “Further disruption in the Red Sea or other key trade channels represents potential upward momentum for inflation,” complicating prospects of the 10-year Treasury yield BX:TMUBMUSD10Y falling below 4 hold %.
There are several implications at stake for investors, ranging from the possible need to recalibrate the financial market's inflation outlook and the expectation of lower interest rates next year. While inflation has fallen from a peak of 9.1% in June 2022 – when gas prices soared based on the overall annual rate of the consumer price index – it is consistently above the Fed's 2% target.
If inflation is expected to rise again, as it did between 1966 and 1982, it would likely drive up market-implied interest rates and force policymakers to back away from recent efforts to prevent further rate hikes gain weight. Late last month, a key official, Fed Governor Chris Waller, raised the possibility that the U.S. central bank could even cut borrowing costs just because inflation is falling, regardless of how economic growth pans out.
“The reason the Fed's reversal happened last week is that we've had enough months where all of these things were going well, where the improvement in inflation seems to be sustained,” said macro strategist Will Compernolle of FHN Financial in New York. “Markets were overly excited about the major narrative shift and may have reacted prematurely.”
A return of inflation would also likely affect what investors do with the nearly $6 trillion pile of cash sitting in money market accounts. Debate has grown over whether some of that pile will stay where it is, returning to stocks or bond funds, depending on whether the Fed cuts rates or leaves them at a 22-year high between 5.25 % and 5.5%. .
On Tuesday, the Treasury market remained relatively stable, with the benchmark 10-year bond yield BX:TMUBMUSD10Y and 30-year yield BX:TMUBMUSD30Y not far from their lowest levels since July at 3.9% and 4%, respectively were. Meanwhile, stocks rebounded, led by a 0.5% rise in the Dow Jones Industrial Average DJIA and Nasdaq Composite COMP in New York afternoon trading.
Bank of America's latest sentiment survey of global fund managers found that one of the biggest foreseen risks is the prospect of high inflation, forcing central banks to keep interest rates elevated.
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