Investors and traders attempting to navigate one of the most treacherous periods in financial markets in years are all but sure to face more volatility during the second half of this year.
One major reason is that few seem to be prepared for the risk that U.S. inflation, already at an almost 41-year high of 8.6% as of May, could prove to be stubbornly resistant to rate hikes by the Federal Reserve. It’s a dynamic that’s played out time and time again during past periods of high inflation in the U.S. — in the 1970s under then-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.
Broadly speaking, financial market participants are increasingly looking for inflation pressures to ease. That’s evident in fed funds futures trades that now predict the central bank will hit the peak of its rate-hike cycle around next March — when the Fed’s main policy rate target could go to between 3.5% and 3.75% or higher, versus its current level between 1.5% and 1.75% — before policy makers cut rates next year.
Expectations for cooling price gains can also be seen in 5-, 10- and 30-year break-even rates trending below 3%, according to Tradeweb — levels which imply the Fed will ultimately win its war on inflation. And hope can even be found in the greater weight that investors are giving to a possible U.S. recession — which, in and of itself, is supposed to cool off inflation.
But in the corner of the financial market where traders stand to make as much as $1 million on a single trade by getting inflation just right — the inflation-derivatives market —the annual CPI rate is seen as running hot for at least five more months: As of Tuesday, fixings traders were pricing in an annual CPI rate that hits 8.9% for June, 8.8% in July, almost 9% in August, 8.9% in September, and 8.1% in October. This is the case despite the chance that the Fed might deliver another 75 basis point hike next month, and policy makers remain in a vigilant policy stance.
Fixings traders also don’t expect inflation to drop below 7.2% for the rest of this year. That’s in contrast to the expectation of 54 economists in The Wall Street Journal’s June survey, who see annual CPI dropping to just below 7% in December.
“The market has been looking to rallies to make up for losses this year, and it’s fair to say it isn’t ready for inflation that proves resistant to Fed rate hikes,” said Rob Daly, director of fixed income for Glenmede Investment Management in Philadelphia, which oversees about $4.5 billion in fixed-income assets. “I think we’re in for a rough ride 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, `Is inflation going to come down and how much will it come down?’ If inflation comes down and seems to stabilize at lower levels, the market can get traction,” Daly said via phone. “But you need to see a rate-of-change dynamic over multiple periods in order to get more comfortable with putting money at risk.”
This year’s carnage in bonds 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 U.S. stock market fell into a bear market earlier this month and all three major indexes
gave up early opening gains on Tuesday after a weaker-than-expected consumer confidence report.
Big-name economists like Treasury Secretary Janet Yellen aren’t the only ones acknowledging they got it wrong on inflation. So is ARK Invest CEO Cathie Wood, who told CNBC on Tuesday that she dramatically underestimated the severity of inflation and that the U.S. is likely already in a recession.
Nonetheless, Jay Hatfield, chief executive of Infrastructure Capital Advisors, and Steve Englander, head of global G-10 FX research and North America macro strategy at Standard Chartered Bank, are among those holding on to the view that inflation could peak in the second half and slow in coming months.
Already, “demand is softening, wages are lagging and oil demand will be coming off — all of those have implications for prices,” Englander said via phone. Even if annual readings continue to come in close to 9% for a period of time, it’s the month-over-month changes and core readings excluding food and energy that matter more in his mind. However, he said, “if we’re wrong, that means the market is underpriced for such a scenario.”
Meanwhile, Hatfield points to the falling prices of commodities ranging from grain to aluminum and steel, as reasons to think that inflation pressures might ease in July’s data, which is released in August. Even if higher shelter costs are “stickier” and may support a more pessimistic view on inflation, he said the greater risk to financial markets isn’t inflation that keeps going higher, but in the chances that the Fed commits a policy error by hiking rates too much. He expects the Fed to pause 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 will probably go into a deep recession and the rest of the world will crack before the U.S. does,” he said.
Trouble remains, though, if inflation eases, yet doesn’t ease enough. “It’s not the absolute level of inflation that matters most from here, but the stickiness. That’s where the rubber meets the road,” said Chief Investment Officer Neil Azous of Rareview Capital in Las Vegas. “I believe inflation will stay elevated for longer, above 5%, and the Fed will have to react to that. Inflation will remain the overriding factor, not weaker growth and recession risk. When inflation remains elevated for an extended period, it becomes more entrenched 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 level where interest rates end up, “will be higher than 4% and potentially on its way to 5%,” Azous said via phone. Still, he says, the “truth will probably lie somewhere in the middle” of the outlook expressed by fixings traders and the expectations of economists.