Investors are obsessed with the magnitude of the Fed’s next rate hike. Here’s what they’re missing.

Debate has simmered over whether Federal Reserve policymakers will raise the federal funds rate by three-quarters of a percentage point later this month, as they did in June, or step up their campaign to fights inflation with a full one-point hike—-something that hasn’t been seen in the past 40 years.

Friday’s economic data, which included somewhat improved or flat inflation expectations from the University of Michigan Consumer Survey, prompted traders to revise expectations lower for a 100-point rise. basis in less than two weeks. The magnitude of the Fed’s next rate hike, however, could be cringeworthy at this point, given the larger and overwhelming problem facing officials and financial markets: a 9.1% inflation rate. for June which has not yet peaked.

Generally speaking, investors are eyeing a scenario in which inflation peaks and the central bank is finally able to reverse aggressive rate hikes and avoid plunging the US economy into a deep recession. Financial markets are inherently optimistic and have struggled to price in a more pessimistic scenario in which inflation does not come down and policymakers are forced to raise rates despite the ramifications for the world’s largest economy.

It was a key reason financial markets turned fragile a month ago ahead of a 75 basis point rate hike by the Fed, the biggest hike since 1994 – Treasuries, equities, credit and currencies all showing friction or stress before June 15th. decision. Fast forward to today: Inflation data has only improved, with annual CPI above 9.1% for the month of June. On Friday, traders were forecasting a 31% chance of a 100 basis point move on July 27 – down significantly from Wednesday – and a 69% chance of a 75 basis point rise, according to the CME. FedWatch Tool.

“The problem is no longer about 100 basis points or 75 basis points: it’s about how long inflation stays at those levels before falling,” said Jim Vogel, interest rate strategist at FHN Financial in Memphis. “The longer this lasts, the more difficult it is to achieve any rise in risk assets. There’s simply less upside, which means it’s harder to bounce off any round of sales.

The absence of buyers and the abundance of sellers lead to gaps between bid and ask prices, and “it will be difficult for liquidity to improve given certain misconceptions in the market, such as the idea that inflation can peak or follow economic cycles when there’s a ground war going on in Europe,” Vogel said by phone, referring to Russia’s invasion of Ukraine.

Financial markets are fast-moving, forward-looking, and generally efficient at evaluating information. Interestingly, however, they struggled to abandon the optimistic view that inflation should decline. The June CPI data showed that inflation was broad-based, with virtually all components stronger than inflation traders expected. And while many investors are counting on the fall in gasoline prices since mid-June to bring July inflation down, gasoline is only part of the equation: gains in other categories might be enough to offset this and produce another high impression. Inflation derivatives traders were expecting to see three more CPI readings of over 8% for July, August and September – even after factoring in lower gasoline prices and rising Fed rate.

Ahead of the Fed’s decision, “there will be dislocations between assets, there’s no other way to tell,” said John Silvia, the former chief economist at Wells Fargo Securities. The stock market is the first place where these dislocations have appeared because it has been more expensive than other asset classes, and “there are not enough buyers at existing prices compared to sellers”. Credit markets are also struggling, while Treasuries – the most liquid market on the planet – are likely to be the last place to be hit, he said over the phone.

“You have a lack of liquidity in the market and bid-ask spreads, and it’s no surprise why,” said Silvia, now founder and managing director of Dynamic Economic Strategy at Captiva Island. , in Florida. “We are getting inflation so different from what the market was expecting, that the positions of market players are noticeably misplaced. The market cannot adapt to this information so quickly.

If the Fed decides to hike 100 basis points on July 27 – bringing the federal funds rate target to between 2.5% and 2.75% from a current level of between 1.5% and 1, 75% – “there will be a lot of losing positions and people on the wrong side of this trade,” he said. On the other hand, a 75 basis point rise would “disappoint” on fear that the Fed is not serious about inflation.

All three major US stock indexes have posted double-digit losses since the start of the year as inflation rises. Friday, the industrialists of Dow DJIA,
+2.15%,
S&P 500 SPX,
+1.92%
and Nasdaq Composite COMP,
+1.79%
posted weekly losses of 0.2%, 0.9% and 1.6%, respectively, although they each ended strongly higher for the day.

Over the past month, bond investors have oscillated between selling Treasuries in anticipation of higher rates and buying them on fears of a recession. Yields on 10- and 30-year Treasuries have each fallen three of the past four weeks amid renewed interest in public debt safety.

Long-term Treasuries are one part of the financial market where there has been “arguably less financial dislocation,” said economist Chris Low, Vogel’s New York colleague at FHN Financial, although a curve of the Deeply reversed Treasury supports the notion of a deteriorating economy. outlook and the markets could be stuck in a turbulent environment that will last as long as the financial crisis and recession of 2007-2009.

Investors concerned about the direction of equity markets, while seeking to avoid or reduce cash and/or bond allocations, “can still participate in the potential upside of equity market returns and eliminate a predefined amount of risk. bearish through options strategies”. said Johan Grahn, vice president and head of ETF strategy at Allianz Investment Management in Minneapolis, which oversees $19.5 billion. “They can do it themselves or invest in ETFs that do it for them.”

Meanwhile, one of the defensive plays bond investors can make is what David Petrosinelli, a senior trader at InspereX in New York, describes as “barbelling,” or owning securitized and government debt in the weaker parts. shortest and longest of the Treasury curve – a “proven strategy in a rising rate environment,” he told MarketWatch.

Next week’s economic calendar is relatively light as Fed policymakers head into a blackout period before their next meeting.

Monday brings the NAHB homebuilder index for July, followed by June data on building permits and housing starts on Tuesday.

The following day, a report on existing home sales in June is expected to be released. Thursday’s data is comprised of weekly jobless claims, the Philadelphia Fed’s July manufacturing index and June’s leading economic indicators. And on Friday, the S&P Global US Manufacturing and Services Purchasing Managers Indices are released.

Leave a Comment