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Market Extra: Stronger-than-expected U.S. inflation data has bond traders weighing the risk of a Fed policy error

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Stronger-than-expected U.S. inflation data for September has the bond market now considering the risk that the Federal Reserve may end up being forced to tighten interest rates into a stagnating economy with persistently higher price gains.

Consumer price readings have come in at 5% or higher on a year-over-year basis for five straight months, undermining the “transitory” theme put forward by central bankers. Bond traders reacted to Wednesday’s report by sending Treasury yields lower on maturities from seven years and out, causing the widely followed spread between two- and 10-year Treasury yields to narrow.

Wednesday’s market moves are important because they signal what some economists say is a profound shift that’s under way in the minds of traders and investors. Until recently, many had chosen to give the Fed the benefit of the doubt, siding with the central bank’s transitory narrative. But the post-CPI drop in Treasury yields — with the exception of rates between the 3-month bill and the 3-year note, which moved higher — included a surprising, temporary decline in the five-year rate
TMUBMUSD05Y,
1.071%

to as low as 1.047%, a yield that reflects what would presumably be the Fed’s entire, forthcoming rate-hike cycle.

The Dow Jones Industrial Average DJIA also dropped by around 100 points, or 0.3%, while the S&P 500 SPX was marginally lower, although the tech-heavy Nasdaq Composite Index
COMP,
+0.45%

was up by 0.4%

“The inflation numbers weren’t great and people think the Fed is not going to let inflation get out of hand,” said David Petrosinelli, a senior trader at InspereX in New York, in a phone interview. “Right now, there are a basket of things going on. One of them is that the Fed’s hand may be forced to unwind QE purchases faster than Chairman Jerome Powell would like. The policy error would be that the Fed has waited too long to hike, and may be forced to hike by too much.”

The data released on Wednesday showed consumer-price gains rising at a 5.4% year-over-year pace last month, above the 5.3% consensus estimate, and staying at a 30-year high. That’s more than double the Fed’s 2% target, and confirmed fears that many forecasters have been underestimating the underlying strength behind the recent surge of inflation. Echoing a similar sentiment on Tuesday was Atlanta Fed President Raphael Bostic, who said the rise in inflation should no longer be considered “transitory,” in an apparent break with other Fed leaders.

Minutes of the Fed’s Sept. 21-22 meeting will be released at 2 p.m. Eastern time, and may provide more details on policy makers’ statement last month that the tapering of $120 billion in monthly bond purchases “may soon be warranted.” Analysts expect a tapering announcement to come at the Nov. 2-3 gathering, with the entire process of pulling back on bond purchases likely to last for months.

The Fed has held the target for the fed-funds rate between 0 and 0.25% since March 2020, to support a pandemic-stricken U.S. economy. It isn’t expected to start raising rates again until sometime next year.

At New York-based BlackRock Inc., Rick Rieder, chief investment officer of global fixed income, said

Inflation fears appear to have already begun denting consumer and business confidence, though the September data reflected “moderate growth in prices” relative to mid-year, said Rick Rieder, chief investment officer of global fixed income at BlackRock Inc., which manages $2.7 trillion in fixed-income assets.

Policy makers have “generally navigated the economic side of the COVID crisis decently well,” though they seem to have fallen “behind the curve in the last six months, or so,” Rieder said in a Wednesday note. “It would be greatly disappointing to see the central bank not only not `stick the landing’ but in fact stumble in a way that injures the recovery.”

After Wednesday’s CPI report, a multitude of buyers stepped into the Treasury market from a variety of accounts, including central banks, according to trader Tom di Galoma of Seaport Global Holdings in Greenwich, Connecticut. Decent demand also came from investors in Japan and China overnight, while U.S. hedge funds were “being forced to cover” after selling off Tuesday night.

“The debate currently going on in the market is, `Is this economy going to be 2% to 3% in GDP going forward?” di Galoma said via phone Wednesday. “There are a lot of constraints in the economy, as far as supply-and-demand issues, that seem to be causing the inflation that we’re seeing. It’s very much a possibility that Fed officials have waited too long to start tightening and start cutting back on all the QE they’ve been doing.”

Related: How stock-market investors can make sense of supply-chain chaos

“We’re at a point where things aren’t clicking as they should be, and Powell’s being forced into a position of scale back QE at a time when it should have been done six months ago,” he said.

Market Snapshot: Dow trades 100 points lower, S&P 500 struggles for direction as slide in Treasury hobbles bank stocks

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