Investors cringed after the release of government data on Tuesday that reversed the trend of falling inflation and signaled that the Federal Reserve’s campaign to curb rising prices is far from over.
After choppy morning trade as investors digested the latest inflation data, the S&P 500 fell 0.5 percent for the day. US Treasury yields rose, reflecting expectations of higher interest rates as the Fed tries to bring inflation back under control.
Investors had taken solace in recent months from a sustained slowdown in inflation, which helped push the US benchmark stock index up more than 6 percent in January. The prospect of a further slowdown in inflation fueled hopes that the Federal Reserve would soon end its ongoing rate hikes, which have helped lower inflation but have also increased costs for consumers and businesses by making credit cards more expensive to use or take out business loans.
That exuberance had come under pressure in recent weeks, with the S&P 500 climbing just 1.4 percent higher this month ahead of Tuesday’s latest CPI release. Data for January showed that price increases accelerated on a monthly basis, although year-on-year numbers continued to show some easing.
“This idea that we can achieve sustained disinflation without a significant slowdown in the economy was the narrative the market ran on,” said Priya Misra, rates strategist at TD Securities. “But that’s come under pressure and amplified it today.”
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The slump in equity and bond markets this year has been painful and it remains difficult to predict the future.
A robust job market, rising used car prices and upward revisions to past inflation numbers had already complicated the picture for investors.
At the same time, policymakers have reignited expectations that the Fed would continue to hike rates through mid-year, pushing up US Treasury yields and weighing on stock prices.
The yield on the two-year government bond rose to over 4.6 percent on Tuesday, hitting its highest level for the year. The yield, which is sensitive to changes in Fed policy, had already risen about 0.25 percentage point ahead of the read this month — the size of a typical central bank rate hike.
And the US dollar’s continued weakness against a basket of currencies representing its major trading partners had continued. On Tuesday, the dollar rebounded from earlier losses after the new inflation data was released.
Bond investors had already begun to recalibrate their expectations for the number of Fed rate hikes.
In early February, futures markets, which allow investors to bet on interest rate movements, indicated a consensus view that the Fed would hike rates by just one more quarter point in March. That has now turned into a decent probability that there will be three hikes of that magnitude by July of this year, which would put the Fed’s interest rate in a range of 5.25 to 5.5 percent, above the Fed’s own forecasts, which were released in December.
It marks a significant turnaround from the market’s skepticism about the Fed’s forecasts just a few weeks ago.
“If you ask 10 people what they think inflation will do, you get 12 opinions with compelling arguments,” said Jim Sarni, a managing director at wealth manager Payden & Rygel, who claims inflation is peaking despite the pace His moderation is slowing down and there are occasional monthly “blips”.
Such mixed signals in the market this year reflect the uncertain outlook noted by Mr. Sarni. Inflation is falling and the economy remains resilient, giving investors hope that a severe downturn will be avoided. However, inflation remains high and parts of the economy are proving resilient to the Fed’s actions, raising the risk that the central bank will have to do even more to slow the economy.
“Last year we had too much pessimism, but now we have a market that has overtaken itself and is a bit too optimistic,” Mr Sarni said. “Because of this, markets are vulnerable in the short term.”
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