Why a single U.S. inflation report rocked global financial markets — and what comes next

It was the only report heard anywhere in the world, shaking the confidence of traders and investors on three continents.

Stocks sold off across Asia and Europe on Wednesday, a day after the August U.S. Consumer Price Index report sparked the worst day for the Dow Jones Industrial Average DJIA,
+0.10%,
S&P 500 SPX,
+0.34%
and Nasdaq Composite COMP,
+0.74%
in more than two years.

The policy-sensitive 2-year Treasury yield, linked to the expected short-term path of Federal Reserve policy, traded at its highest level in nearly 15 years – largely driven by expectations about how high the US central bank could end up taking interest rates. And the greenback – often linked to the trajectory of US interest rates relative to the rest of the world – remained near 20-year highs, as measured by the ICE US Dollar Index DXY,
-0.14%.

The continued fallout from the CPI report underscores how misplaced global financial market participants were in thinking U.S. inflation could come down significantly and quickly, analysts said.

It’s not the slight drop in the annual rate, to 8.3%, that has caught the most attention; investors instead focused on, among other things, the smaller monthly reading that excludes energy and food, which doubled to 0.6% from 0.3% the previous month.

Traders started pricing in a decent chance of a 100 basis point rate hike by the Federal Reserve next week, but were equally concerned about the destination of rates: Companies like PIMCO and Jefferies signaled the possibility of an above-target increase in the federal funds rate expected at 4.5%, which is currently between 2.25% and 2.5%.

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“All the hope of the previous month’s inflation reports has been dashed – not just by a little, but by double,” said Will Compernolle, New York-based economist for FHN Financial, referring to the scale of the change in August core CPI monthly gauge. . “Before Tuesday, there was a belief that, as bad as things were, they probably weren’t going to get any worse and people had expected some improvement in inflation and the Fed’s path.”

“The data is shaking confidence in how bad things are and how serious they are,” he said by phone Wednesday. “It’s reverberated around the world because so many countries are coming to grips with their own inflation problems, which are largely tied to rising energy costs and are priced in dollars. And the Worsening US inflation which leads to a tightening of Fed policy leads to an appreciation of the dollar and accelerates the energy crisis for other countries.

See: Why an epic US dollar rally could be a ‘wrecking ball’ for financial markets

Worse still is the speed with which US policymakers are prepared to act to quell the hottest inflationary fire in four decades. On August 26, Federal Reserve Chairman Jerome Powell delivered a direct message at the central bank’s Jackson Hole retreat that the Fed will continue to try to bring inflation down until the job is done, and that higher rates will cause “households and businesses suffering”. .” Dow Jones industrials closed over 1,000 points on the same day, and all three major US indices ended the week with losses.

Tuesday’s sharp sell-off in U.S. stocks was the second time in less than three weeks that equity investors have been so badly burned in a single day. US stocks consolidated in choppy trade on Wednesday, ending slightly higher as traders and investors weighed what might come next.

“We could get to 4% federal funds so quickly, relative to recent historical episodes, that it’s hard to say how the world will adjust,” FHN Financial’s Compernolle told MarketWatch. “When you couple energy costs in emerging markets with a lot of dollar-denominated debt, it’s unclear what a 4.5% federal funds rate does to those sources of distress. It’s hard to see that nothing is breaking – whether it’s housing in the United States, political unrest in countries with energy crises, you have to think something is going to break.

Related: A rising US dollar is already sending ‘danger signals’, economists warn

Buried inside the August CPI report were fresh signs of continued general inflation, despite an annual headline rate that fell to 8.3% from 8.5% in July: in particular, price increases for a wide range of services n showed no signs of slowing down.

The CPI report “was a sign that inflation is more entrenched than people expected at this point, despite the sharp slowdown in the U.S. economy,” said Mark Heppenstall, chief investment officer of Penn Mutual Asset Management, which manages more than $30 billion from Horsham, Pennsylvania. “We still haven’t seen a meaningful turnaround in inflation, and the core number in particular must have been troubling for the Fed. Inflation was expected to turn quickly and sharply and yesterday’s figure was a reality check.

Lily: Falling gasoline prices gave Americans false confidence that inflation was cooling at a faster rate. The August figures disappointed analysts, Wall Street and consumers.

“To the extent that inflation has become more entrenched, this will cause an immediate reassessment of the level of risk people can take, especially with growing businesses where the discount rate on future earnings has more impact. “, he said by telephone. Meanwhile, Heppenstall said, Penn Mutual has recently found attractive new investment opportunities in short- to mid-duration fixed-income assets.

On Wednesday, Japan’s Nikkei 225 NIK,
-2.78%,
The Chinese Shanghai Composite SHCOMP index,
-0.80%,
and the Hong Kong Hang Seng HSI Index,
-2.48%
posted their largest single-day declines in the past three weeks to three months. Stock indices in the UK, Germany, Spain in the Netherlands, Switzerland and Stockholm also suffered declines. And the yield on the 10-year gilt BX:TMBMKGB-10Y, the UK counterpart to Treasuries, hit a 10-year high earlier in the day as investors sold bonds, the fastest growing asset class. hard hit by inflation.

Tuesday’s strong sell-off in U.S. stocks was wiped out $1.5 trillion in value of the S&P 500, according to FactSet. The fall in stocks was reportedly exacerbated by institutional traders and others who exited big leveraged bets, via the options market, that inflation would slow.

“A lot of people were caught on the wrong side of Tuesday’s CPI report,” said Angelo Kourkafas, investment strategist at Edward Jones in St. Louis. “It was the combination of upside surprise and positioning that led to a sell-off in the US”

Continued Fed rate hikes “clearly increase the risk of a recession and increased equity volatility, with the possibility that we could still revisit June lows,” he told MarketWatch by phone. . “From an investment perspective, we expect greater near-term volatility, some upward pressure on bond yields and potentially some weakness in the growth segments of the market.”

Shortly after the August CPI, the US bond market began pricing a terminal fed funds rate of at least 4.5%, extending the Fed’s rate hike cycle to Q1 2023. , said Neil Azous, chief investment officer of Rareview Capital in Las Vegas. , investment advisor and sponsor of ETFs with over $150 million in assets under management. That compares to a terminal rate of 4% by December that was expected before Tuesday’s data release, he said.

Separately, the real 5-year, or inflation-adjusted, rate as measured on Treasury inflation-protected securities jumped above 1% on Tuesday to its highest level since. December 2018, according to Tradeweb data. Historically, whenever real interest rates go above 1%, “two bad things happen: credit markets start to clog and the S&P 500 contracts multiple,” Azous said.