Market meltdown is an ominous sign for interest rates
One glance at the reaction of financial markets and it was instantly obvious that the US August inflation numbers were not what the markets expected or wanted.
The US sharemarket plunged 4.3 per cent – its biggest fall since June 2020 in the earliest days of the pandemic – and interest rates in the bond market shot up. The yield on 10-year bonds rose six basis points to 3.42 per cent and two-year Treasury note yields 19 basis points to 3.76 per cent. The two-year yields are now at their highest level since October 2007.
Wall Street plunged after the release of the inflation data.
Wall Street plunged after the release of the inflation data.CREDIT:AP
Expectations in the market in the lead up to the release of the data had been quite optimistic, drawing on some positive recent economic data to believe that the inflation rate in the US, while still high, had peaked and was subsiding and therefore the moment when the US Federal Reserve ended this cycle of rising rates was not that far distant. The data dashed those hopes.
Headline inflation of 8.3 per cent was 10 basis points higher than in July, albeit 20 basis points lower than the 8.5 per cent posted in August last year. The core inflation rate, which strips out some of the more volatile inputs like fuel and food costs, rose 0.6 per cent from July and was 6.3 per cent higher than a year earlier – a 40-year high.
Those aren’t data points consistent with a peaking of inflation and the headline number is actually worse than it looks given that the oil price – and fuel prices in the US – have fallen quite materially. In August, fuel prices were 10 per cent lower than in July.
Its rents, food and healthcare costs are rising aggressively, along with wages that are increasing in a very tight labour market (albeit not at the rate of inflation). It is the breadth of the increases as much as the overall rate that is disturbing.
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Where, ahead of the release of the data, most in the market were confident that the Federal Reserve Board’s next rate rise would be 50 basis points, the disclosure of stubbornly persistent inflation caused an immediate reappraisal.
There is now an expectation that, when the Fed’s Open Market Committee meets next week, it will raise the federal funds rate by 75 basis points, its third consecutive outsized move, with the odds on an ultra-aggressive 100 basis point hike rising to more than one in three.
The bond market has crashed as investors have slowly realised that the Fed and the other major central banks are going to keep raising rates until they have crushed inflation rates.
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There is a strong argument for that larger move and for further (perhaps not quite as large) rises at the remaining committee meetings in November and December.
The Fed needs to get ahead of expectations and make a significant dent in consumer and investor confidence – and probably economic growth in the process – if it is to drive the inflation rate down. It is also probably going to have to keep raising rates faster and further than it might itself have envisaged.
Where those in the markets saw rates peaking either late this year or early next year around 4 per cent, it now looks likely that peak will occur well into next year and solidly above 4 per cent, although this is, of course, a volatile environment.
The data, self-evidently, wasn’t good news for investors in either equities or bonds in what has been a horrible year thus far for investors.
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The US sharemarket is down about 18 per cent this year and bond market investors are experiencing their first bear market in decades. Worst-hit have been investors in technology and other high-earnings multiple stocks, with the tech-laden Nasdaq index down 5.2 per cent in response to the inflation numbers and now down 27 per cent from its peak late last year.
The data, and the Fed’s likely response, is also ominous for markets and economies outside the US given that the Fed’s chairman, Jerome Powell, has made it clear that the Fed will be driven by the data and do what it takes to bring inflation under control.
Not only does the US Treasury market act as a benchmark for all other bond markets but rate differentials between the US and other economies drive currency movements.
As the Fed has moved faster and harder than the other major banks this year, the US dollar has strengthened almost 15 per cent against the basket of its major trading partners’ currencies. If they want to avoid destabilising capital outflows and depreciation of their own currencies (and higher inflation as a result) other central banks are under increasing pressure to emulate the Fed.
The strengthening of the dollar has particularly unpleasant impacts of economies that need to import commodities (most of which are priced in US dollars) and which have high levels of US dollar-denominated debt.
The Fed is struggling to rein in US inflation.
The Fed is struggling to rein in US inflation. CREDIT:AP
Those are generally the emerging market economies, although the energy crisis in Europe and Europe’s mad scramble to secure supply at any price to replace gas that used to flow from Russia means the eurozone, too, will now be under even greater pressure.
While the European Central Bank recently increased its policy rate by a record 75 basis points, at 1.25 per cent the ECB is well behind where the Fed is today let alone where it might be next week and is in the uncomfortable position of knowing it has to raise rates to kill of surging eurozone inflation rates and avoid being crushed by dollar strength even as the zone heads almost inexorably towards recession.
The Reserve Bank doesn’t confront the ECB’s challenges but it has always been very conscious of the implications of the Fed’s decisions for the value of the Australian dollar and the flow-on effects of currency weakness on inflation and growth.
Although the US may be comforted by the anti-inflationary impact of the surging dollar, it should worry about what the currency’s strength says about the prospects for the rest of the world.
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The only brighter spots in the macro settings are the falls in oil prices – the price is now down below $US94 a barrel from a peak earlier in the year of almost $US130 a barrel and OPEC is cutting rather than increasing supply – and signs that the disruptions to global supply chains that have bedevilled the global economy and played a major role in igniting the breakout of global inflation are gradually disappearing.
Those positives, however, only serve to stress how challenging and stubborn the current high-inflation environment is and make it more likely than not that central banks will be forced into far more aggressive action than they, or those in the market, were anticipating even in the days leading up to the latest release.