There is a subtle shift in some corners of the financial market to the view that the US economy may be strong enough to support higher interest rates that reduce inflation.
Signs of that shift in sentiment were evident in fed funds futures, where traders mostly priced in the chances of a rate cut in 2023. And stocks pared their earlier losses on Wednesday, even after the minutes of the Federal Reserve’s July meeting revealed that policymakers see a risk that they may have to tighten more than necessary.
Sentiment has oscillated over the past week between optimism that inflation is fading — as expressed by U.S. stock indexes that remain well off mid-June lows — and pessimism that increases in the Federal Reserve to fight inflation will produce an economic recession, as reflected in a deeply inverted Treasury yield curve. Although July’s consumer price index report noted that the drivers of inflation were “showing some relief,” a still-strong U.S. economy keeps alive the risk of a couple more rate hikes rate by 75 basis points by the Fed, said Ed Moya, senior market analyst. for the Americas in Oanda.
“The market has come to the view, and I don’t know if it’s correct to be honest, that given some of the strength that we’ve seen in earnings and the labor force, maybe this Fed tightening is allowing policymakers to potentially sailing into a soft landing,” said Rob Daly, director of fixed income at Glenmede Investment Management in Philadelphia.
“Personally, I’m not in that camp and I think we have more wood to chop,” Daly said by phone. “We haven’t seen the knock-on effects of the rate hikes yet and inflation is still a problem. Inflation went from 9.1% to 8.5% and could potentially come down, but where will it settle? It won’t go to 2% quickly, and that puts the Fed in a box and it will be difficult to navigate its inflation mandate.”
The better-than-expected improvement in July’s CPI data gave many hope that inflation could peak, while reinforcing the hawkish view in currency and rate markets that the Fed needs a persistently strict policy to reduce price gains. The subtle shift in thinking now taking place is that the economy may be stronger than previously thought, as reflected in better-than-expected earnings and revenue for Walmart Inc.’s fiscal second quarter. WMT, +0.13% Also, while retail sales were flat in July, the data contained enough kernels of good news to satisfy optimists.
“The outlook for the economy has changed,” Moya de Oanda said in a telephone interview. “We were looking at a slowdown in June and July, and that’s not the case. Walmart and retail sales are supporting the bullish outlook this week.”
Of course, financial markets continue to absorb a flood of data since the August 10 CPI release that keeps inflation worries alive, including Wednesday’s report that annual UK consumer prices increase by 10.1% in July.
And the results of an online survey of 70 business executives, entrepreneurs and private equity investors from July 18 to August 5 showed that 50% were “very concerned” about the impact of inflation on the foreseeable future, according to Stifel, Nicolaus. & Co.
“The issue of high inflation continues to weigh on developed markets and will likely do so for the balance of the year,” said BMO Capital Markets strategist Ian Lyngen.
Still, the latest shift in sentiment reflects some adjustment from the second quarter, when fears of an impending U.S. recession dominated. Concerns about a fall have not completely disappeared; in fact, the Treasury curve still shows a warning, via a deeply negative spread between 2-year and 10-year rates. But behind that worrisome signal is the fact that Fed fund traders have largely dismissed the possibility of a rate cut by the Fed next year.
“Surprisingly, there has been very little warning or commentary that expectations of Fed rate cuts in 2023 have all but disappeared recently,” said John Vail, chief global strategist at Nikko Asset Management. “Indeed, while feeder fund futures predicted cuts in the first half, a rise is now partially priced in, while only predicting less than a 25bp cut in 2023. This is likely due to Fed speeches rather than any change in macroeconomic fundamentals.”
Vail wrote in an email that the recent stock market rally and the resulting loosening of financial conditions likely also play a role in expectations that the Fed will not have to cut rates. “This corroborates our view that the Fed should be more dovish than consensus due to sticky core inflation, and will likely be a headwind for risk markets once properly realized,” said the strategist
All three major stock indexes DJIA, -0.51% SPX, -0.72% COMP, -1.25% were lower after the release of the Fed minutes, but pared earlier losses. Meanwhile, a selloff in government bonds pushed the 2-year yield TMUBMUSD02Y, 3.286% to around 3.27% and the 10-year yield TMUBMUSD10Y, 2.897% to 2.86%.
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