Some investors who took comfort in last week’s moderating inflation numbers are leaning more into bets that prices will peak, a trade that has stung over the past year.
July’s consumer price index has fueled new bets that inflation is more circumstantial than structural and that the Federal Reserve will moderate its rapid pace of rate hikes in response. Investors now expect a lower rate hike from the Fed in September, continued to price in rate cuts in the first half of next year, and bought shares of technology companies, which are poised to perform well if rates are slackening.
Such moves indicate that many investors still see a relatively quick end to the persistent rise in prices, even as Fed officials warn of the need for further rate hikes, which could undermine recent gains in stock and bond markets. .
“I think what the Fed is telling us is correct: the job is not done,” said Michael Sewell, bond portfolio manager at T. Rowe Price..
“The problem with this recent rally in risk assets is that if the Fed thinks its job is done, we run the risk of another spike in inflation.”
In a sense, traders who follow inflation closely are back in familiar territory. Current bets in the derivatives markets predict that inflation will be around 3.3% over the next 12 months. This is precisely where the estimates were this time last August.
Over the past 12 months, however, prices have actually risen nearly three times as fast, sending stocks and bonds tumbling for much of 2022 as traders braced for the Fed’s response. Even so, many investors are again betting on a relatively quick decline in inflation, relying on the latest CPI numbers as well as signals from the bond market, businesses and consumers that a slowdown economy could be underway.
Bob Miller, Managing Director of Fixed Income at BlackRock,
said investors’ current views on inflation echo their bets from a year ago. Time has proven those predictions incorrect, but now Fed rate hikes have started to dampen price growth, he said.
“It’s ironic that one-year futures are pricing something similar to what one-year futures were pricing a year ago, which was wildly incorrect,” Miller said. “But it’s important to recognize what changed that year.”
As the Fed withdrew its pandemic-era economic support, financial conditions have tightened significantly, Miller said. This has already cooled the housing market and will likely slow the economy more broadly over time as higher borrowing costs trickle down, he said.
Gaining confidence in the Fed’s progress, investors rolled back trades that were snuffed out by rate hikes earlier in the year.
Treasury bill yields, which largely reflect interest rate policy expectations, have fallen. The 10-year yield stood at 2.848% on Friday, down from a high of 3.482% in June. Tech stocks have rallied, sending the Nasdaq index up 23% since mid-June. Earlier in the year, rising rates hurt the index by reducing the relative attractiveness of investing in companies with distant profit potential.
Changes in investor expectations of Fed policy have recently triggered rapid swings in bond markets. Bond traders initially interpreted Chairman Jerome Powell’s press conference at the central bank’s July meeting as a signal for looser policy, only for that trade to ease a few days later as other central bank officials doubled down on the Fed’s tough line against rising prices.
Trading after the July CPI report last Wednesday followed a similar trend. Treasury yields initially fell rapidly after the release of weaker-than-expected price data, signaling the perception of looser Fed policy ahead. By the end of the day, yields rebounded, regaining much of the lost ground.
Alex Gurevich, chief investment officer of HonTe Advisors, still predicts growth and inflation will fall faster than many others now expect, citing his research on past business cycles.
“Typically, when the market starts to price rate cuts, the cuts will happen faster than the market anticipates,” Gurevich said. “It always happens faster than people think.”
This means a bet that the Fed’s interest rate policy easing will happen sooner than expected by the central bank’s own officials. Neel Kashkari and Charles Evans, two regional Fed chairs who are not part of the rate-setting committee, argued last week that more aggressive measures will still be needed to bring inflation under control.
The latest official survey of Fed policymakers, conducted in June, shows most plans to raise rates through 2023 to at least 3.5% to 3.75% or more, vs. current federal funds target of 2.25% to 2.5%. Last month, Mr Powell told reporters that those June projections remained a good guide.
Kashkari, who will vote on Fed policy next year, said the target rate may need to reach 4.4% by the end of 2023.
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Futures markets, meanwhile, are predicting that rates will peak earlier, next spring, and that the Fed will move quickly to an easing policy. Traders in these markets expect the Fed to lower its target rate to around 3.2% to end 2023, according to Tradeweb data.
“I think the market is interpreting Powell’s comments the way they want them to, instead of how Powell intended them to be interpreted,” said Gautam Khanna, portfolio manager at Insight Investment, part of BNY Mellon.
Fed officials have insisted that tackling inflation is their top priority, so a move to another rate cut next year would likely only follow significant price progress, said Mr. Miller of BlackRock.
“It’s funny how that word ‘transitional’ was wiped from all of our vocabularies a year ago,” he said. Now, he added, the transient is precisely what the market is betting on again.
Write to Matt Grossman at email@example.com
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