A subtle shift in financial markets suggests the US economy could handle higher rates

There is a subtle shift taking place in some corners of the financial market towards the view that the US economy may be strong enough to handle higher interest rates that will reduce inflation.

Signs of that shift in sentiment were evident in fed funds futures, with traders mostly discounting the chances of a rate cut in 2023. Stocks, meanwhile, trimmed their earlier losses on Wednesday, even after the Minutes from the Fed’s July meeting revealed that policymakers see a risk that they may need to tighten more than necessary.

The feeling has vacillated during the last week between optimism that inflation is fading, as expressed by US stock indices remaining well below their mid-June lows, and pessimism that Federal Reserve hikes to combat inflation will produce a recession economy, as reflected in a deeply inverted Treasury curve. although july consumer price index report He noted that inflation drivers “show some relief,” a still-strong US economy now keeping alive the risk of a couple more 75 basis point rate hikes by the Fed, said Ed Moya, senior market analyst for the Americas in Oanda.

“The market has come to the conclusion — and I don’t know if it’s correct to be honest — that given some of the strength we’ve seen in earnings and the workforce, maybe this Fed tightening is allowing policymakers to policies to potentially navigate a soft landing,” said Rob Daly, director of fixed income at Glenmede Investment Management in Philadelphia.

“Personally, I’m not in that field and I think we have more wood to cut,” Daly said by phone. “We have not yet seen the collateral effects of rate hikes and inflation remains a problem. Inflation went from 9.1% to 8.5% and could potentially go down, but where is it going to settle? It’s not going to get to 2% quickly, and that puts the Fed in a box and it’s going to be difficult to navigate their inflation mandate.”

July’s better-than-expected improvement in CPI data gave much hope that inflation may be peaking, while reinforcing the dour view in rate and currency markets that persistently tight policy is needed. by the Federal Reserve to reduce price gains. The subtle shift in thinking taking place now is that the economy may be stronger than previously thought, as reflected in better-than-expected earnings and revenue for Walmart Inc. WMT’s fiscal second quarter,
+0.11%
Also, while retail sales came in flat for July, the data contained enough kernels of good news to satisfy bulls.

“The outlook for the economy has changed,” Moya de Oanda said in a telephone interview. “We were seeing a slowdown in June and July, and that is not the case. Walmart and retail sales support the upbeat outlook this week.”

To be sure, financial markets continue to absorb a stream of data since the August 10 CPI release that is keeping inflation concerns alive, including Wednesday’s report that annual UK consumer prices increased 10.1% in July.

And the results of an online survey of 70 corporate executives, business owners and private equity investors from July 18 to August 5 showed that 50% were “very concerned” about the impact of inflation in the foreseeable future, according to Stifel, Nicolaus and company

“The high inflation theme continues to weigh on developed markets and likely will for the rest of the year,” said strategist Ian Lyngen at BMO Capital Markets.

Still, the latest change in sentiment reflects a small adjustment from the second quarter, when fears of an impending recession in the US dominated. Worries about a recession have not entirely disappeared; indeed, the Treasury curve is still showing a warning, via a deeply negative spread between 2-year and 10-year rates. But behind that worrying sign is also the fact that Fed Funds traders have largely ruled out the possibility of a Fed rate cut next year.

“Surprisingly, there has been very little notice or comment on the fact that Fed rate cut expectations for 2023 have all but disappeared recently,” said John Vail, chief global strategist at Nikko Asset Management. “Indeed, while Fed Funds futures once forecast cuts in the first half, a hike is now partially included, while 2023 only predicts less than a 25bp cut. This is likely due to the Fed’s hawkish rhetoric rather than any change in macroeconomic fundamentals.”

The recent stock market rally and resulting easing of financial conditions are also likely to play a role in expectations that the Fed won’t need to cut rates, Vail wrote in an email. “This corroborates our view that the Fed would need to be more aggressive than consensus due to tight underlying inflation, and will likely be a headwind for risk markets once properly noted,” the strategist said.

On Wednesday, all three major stock indices finished lower, with losses led by the Nasdaq Composite COMP,
-1.25%,
following the release of the Fed minutes. Meanwhile, a sell-off in government bonds pushed up the 2-year yield TMUBMUSD02Y,
3.278%
to a two-month high of 3.293% and the 10-year yield TMUBMUSD10Y,
2.888%
up to 2,894%.

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