Fed ahead: more pain for US stocks as inflation roars?

Since the US CPI came in hot at 8.6% last week, US stock markets have had a bad case of the bear blues. This is what’s been happening in the US100 since Wednesday’s print:

A drop of almost 12% from Wednesday’s high to Monday’s low is a bit of a head-scratcher on the face of it. Why would 8.6% inflation cause such a fall in the stock market?

Some of the major concerns stem from uncertainty about the future and the potential central bank response. A consensus had started to form around ‘peak inflation’ but this was soundly disproven on Wednesday. To top things off, inflation was broad-based through many goods and services, and, according to the latest Michigan survey, medium to longer term inflation expectations risk becoming unanchored. The 5-10 year inflation expectations reading jumped to 3.3% vs 3% in May.

The Fed Has To Act

The US central bank had already committed to raise interest rates by 0.5% at each of the upcoming meetings (June & July) and now markets are speculating they’ll be forced to do even more to combat inflation and regain credibility in the battle against soaring prices.

Markets now assign a 95% probability to the Fed making a 75bps move on Wednesday. For context, those odds were just 3.1% a week ago…

CME Fedwatch

What does this mean for stocks?

As always, it depends! In the short term, there’s a case for renewed certainty bringing relief to equity markets, although it remains to be seen if any rally would have legs.

Over the longer-term, higher interest rates generally create a higher risk premium, making equities broadly less attractive against investments such as bonds. The US 10Y treasury is often referenced as the ‘risk-free’ rate that other assets are benchmarked against.

The premise is that if an investor can deposit their funds into a safe asset such as US 10y bonds, riskier assets such as stocks would need to offer a higher premium above the ‘risk-free’ asset to be attractive.

To be clear, ‘risk-free’ is a misnomer. Nothing is risk-free (as holders of US bonds bought at the Covid lows can confirm!), but it’s a useful way of thinking about the appeal of assets relative to each other.

And markets expect interest rates to go even higher over the next 12 months. The chart below shows the futures pricing of interest rates. The recent moves stand out like a sore thumb:

Markets now expect the Fed funds rate to hit 3.96% by June 2023, way above estimates of the neutral interest rate between 2 & 3%. Which means restrictive monetary policy for a while yet (if they're right).

The combination of higher inflation, higher interest rates and a strong dollar hasn’t been good for US company earnings historically, and many companies have become reliant on the ability to cheaply roll debt and grow rather than focus on profitability.

Plenty to consider. And possibly one of the most important Fed meetings of the modern era tomorrow. Can they re-establish credibility and bring some stability to the markets?

Not investment advice. Past performance does not guarantee or predict future performance.