The CPI data released yesterday dampened hopes that the Fed will cut rates as fast as what market initially anticipated. All readings came in hotter than the consensus forecast. Headline inflation did slow further but not as much. The key, however, is that core inflation showed signs of stalling as rental, food, and transport costs rose.
Yields jumped and rate cut expectations moderated after higher inflation reading
The markets tumbled sharply on the news. The greenback and Treasury yields jumped. Compared to the end of January, the yields today are higher almost across the entire curve.
There are also material changes to the number of rate cuts markets now expect. When the year began, the market priced in almost 7 cuts (each cut is 0.25%). As strong economic data came in and the Fed moderated the market, that was adjusted down to around 5 cuts. And after yesterday, we are looking at 3-4 cuts. This is now closer to the 3 cuts that the Fed had in mind which is not necessarily a bad thing as a wide mismatch can cause some nasty volatility. But of course, that is also subject to change depending on how things unfold.
Everything was hit, and there was nowhere to hide
The selling yesterday was broad-based across major asset classes. From equities to fixed income to commodities, none were spared.
Within US equities, all sectors were down in the red as well. The discretionary and interest rate-sensitive REITs were hardest hit.
These bring back memories of 2022. That was when the Fed started its aggressive rate hike regime against soaring inflation. There were burning questions then, such as, how much does Fed needed to hike, when inflation would come down, and whether the economy could withstand the pressure of increasingly higher rates. But much is shrouded in uncertainty then. Today, we are in better shape but a whiff of that uncertainty is back.
Before this, economists had consistently underestimated the strength of the US economy and the labor market. So, going by the same logic, a hotter inflation figure should perhaps not come as a surprise. But, given how markets moved this year before the data was released yesterday, many were perhaps hoping that despite the robust economic readings, rates are restrictive enough to do their job and inflation can still come down as quickly.
Are rates high enough today?
We don't know for sure if the rates are high enough today. Yes, rates have climbed up a lot since the Covid pandemic. In terms of absolute value, they are already as high as pre-Great Financial Crisis (GFC) levels. Back in 2007, high mortgage rates were the catalyst that triggered defaults which set off the GFC.
But the conditions today are different. Our banking system is more robust and heavily scrutinized, consumer debt including mortgage as a proportion of their income is still low, subprime mortgage loans are not pervasive today, margin debt across US brokerage accounts is quite a bit below that in 2022, and the job market remains resilient. Perhaps this explains why spending and sentiments are still strong and how the economy is still able to hold up despite a markedly higher interest rate environment.
This, however, does not mean everything is well and good. There are still risks and like many crises, we often don't see it coming until it is here. For one, even though consumer and corporate debt levels look alright, the US national debt stands at $34 trillion or 120% of its GDP. Unsurprisingly, many said this was unsustainable. But the same was said many years ago, the debt kept growing, and the US is still standing strong today. We all agree this can't go on indefinitely but no one knows when the music will end.
Is inflation coming back then? I don't think anyone knows the answer. But will it come back in a strong way like it did in 2021? Probably not, unless there are external shocks, now that rates are already much higher and the Fed has it firmly fixed on its radar screen. What is holding the Fed back from hiking further now is the prospect of pushing the economy into a recession if they overdo it. They are still trying to engineer a soft landing which seems closer within their grasp with the economy doing better than they anticipated. Unless inflation shows clearer signs of picking up, they are unlikely to flip into a hiking mode. Although not on the cards yet, we can't rule out the Fed cutting less than what they planned for and letting rates hang higher for longer. They pivoted too fast last year. A more hawkish signal might help to dampen sentiments which is needed when you are fighting inflation.
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