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Tuesday’s US CPI data showed inflation remains the market’s principal worry. Core consumer prices rose by 0.6% month-on-month in August versus 0.3% expected, a chilling reminder that the Fed’s war on inflation is not yet won and that inflation fears are the primary source of unwanted volatility at the moment. Equities sold off heavily, credit spreads widened and US Treasury yields edged higher as markets priced in the prospect of further hiking from the Fed.
There have been several calls from commentators for a 100bp hike at next week’s FOMC meeting. A 75bp hike remains our base case, but with inflation driving rates expectations it appears we must wait a little longer before rates volatility subsides.
Had the inflation data undershot forecasts we think Tuesday’s risk tone would have been very different, and it could have been the catalyst for a more sustainable risk rally. Investors must be patient for this to happen, but we don’t think this kind of shift is far away.
Markets are now pricing in aggressive tightening from the major central banks, and we think this is what we will see as the year unfolds. Our base case 75bp hike at next week’s FOMC would take the Fed Funds rate to 3.25%, a level well into restrictive territory for the US economy. We see 4% as a level where the Fed will pause and hold for some time as it waits for its policy action to take effect. At 3.25% then we are likely just a hike or two away from the terminal rate, and history tells us that longer dated UST yields typically peak towards the end of a hiking cycle, meaning the peak in yields may also not be far away.
Should inflation continue to surprise on the upside then this view may not hold true, but we do think there is early evidence supporting the fact that peak inflation is very near and is likely to taper off as the year comes to a close.
With terminal rates in sight and future inflation data likely to be more supportive, we expect to soon see rates volatility dropping off, which we think will be a key catalyst for improved market conditions.
In the short term we may have to continue to be patient before this clarity arrives, but it is worth noting that staying patient is much more palatable when yields and spreads in fixed income are as high as they are at the moment.