Parts of the financial markets are struggling to adapt to the idea that the Federal Reserve might keep raising interest rates even after this week’s data clearly pointed to decelerating inflation.
Late Thursday, Federal Reserve Gov. Christopher Waller indicated he remains unmoved by June’s consumer price index and that he supports two more rate hikes this year even though monthly core inflation was just 0.2%, or half of what was seen in May.
By Friday morning, parts of fixed-income markets “refused to play along,” with rates on overnight index swaps pricing in “just one more hike, not two — suggesting still that the Fed’s hawks have lost some of their credibility,” said Thierry Wizman, Macquarie’s global FX and currencies strategist.
The bottom line from Waller’s speech is that it’s not solely inflation data that’s driving the Fed’s decisions, complicating the assessments made by traders and investors from here. Policy makers want to make sure that the recent deceleration in inflation feeds through broadly across goods and services sectors, and doesn’t revert back to persistently high core readings, according to the Fed governor. What’s more, “the robust strength of the labor market and the solid overall performance of the U.S. economy gives us room to tighten policy further,” he said.
Some important corners of the financial markets did respond to his remarks, namely the Treasury market. Treasury yields were broadly higher on Friday, with the policy-sensitive 2 year yield
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jumping off a one-month low, as fed funds futures traders boosted the likelihood of a post-July rate hike by November. Traders now see a 30.1% chance that the fed funds rate target will either get to 5.5%-5.75% or higher in four months — up from a current level of 5%-5.25% and after factoring in a widely expected quarter-of-a-percentage-point hike on July 26.
However, equity investors were largely focused on other things. U.S. stocks
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mostly reacted to Friday’s batch of good earnings reports from major banks, as well as fresh data from the University of Michigan. Meanwhile, the U.S. Dollar Index
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which typically reacts to changes in U.S. interest-rate expectations, was up by just 0.1% after dropping earlier in the day.
“Inflation coming down has led to market anticipation that the Fed does not have much more tightening to do,” said David Donabedian, chief investment officer of CIBC Private Wealth US, which has $94 billion in assets under management and administration. “And the big banks are looking solid with recent earnings reports. While this might be a short-term swing in sentiment, the market is not fighting the optimism and seems to be pricing in economic nirvana,”
“While we are pleased to see progress on the inflation front, we continue to have concerns about a weakening economy and lower demand that would result to a challenge for corporate earnings,” Donabedian wrote in an email. “There are some economic indicators that look good — like jobs — but these are telling us how the economy is doing yesterday and today. They don’t predict the future.”
As of Friday afternoon, stocks were headed for their fifth day of gains, helped partly by the optimism unleashed from Wednesday’s consumer price report and Thursday’s producer price data. All three major U.S. stock indexes opened higher — brushing aside Waller’s comments — and pared gains only after data from the University of Michigan showed 5-10 year inflation expectations rising this month.
Waller’s speech, delivered to the Money Marketeers of New York University, clearly articulates areas that investors may be missing in their assessments of where the Fed could go with rates, analysts said. In his mind, the impacts of policy tightening from last year “are feeding through to market interest rates faster than typically thought.” In addition, Waller said, households and firms appear to be adapting more rapidly to the dramatic, fast pace of interest-rate changes seen since March 2022.
“If one believes the bulk of the effects from last year’s tightening have passed through the economy already, then we can’t expect much more slowing of demand and inflation from that tightening,” Waller said in his prepared comments.
“To me, this means that the policy tightening we have conducted this year has been appropriate and also that more policy tightening will be needed to bring inflation back to our 2 percent target,” he said. “Pausing rate hikes now, because you are waiting for long and variable lags to arrive, may leave you standing on the platform waiting for a train that has already left the station.”
