Investors are obsessed with the size of the Fed’s next rate hike. Here’s what they’re missing.

A debate has been brewing over whether Federal Reserve policymakers will raise the fed funds rate by three-quarters of a percentage point at the end of this month, as they did in June, or step up their campaign against inflation with a full point increase. something that has not been seen in the last 40 years.

Friday’s economic data, which included somewhat better or stable inflation expectations from the University of Michigan consumer survey, prompted traders to lower their expectations for a 100 basis point rise in less than two weeks. However, the size of the Fed’s next rate hike could be very sensitive right now, given the biggest and most daunting problem facing policymakers and financial markets: a Inflation rate of 9.1% for June that has not yet reached its peak.

Broadly speaking, investors have been imagining a scenario in which inflation peaks and the central bank can finally backtrack on aggressive rate hikes and avoid plunging the US economy into a deep recession. Financial markets are by nature bullish and have struggled to price in a more pessimistic scenario in which inflation remains unabated and policymakers are forced to hike rates despite the ramifications for the world’s largest economy. .

It is a big reason why the financial markets became brittle a month ago, before a Rate hike of 75 basis points by the Fed, which was the largest increase since 1994, with Treasuries, stocks, credit and currencies all exhibiting friction or strain ahead of the June 15 decision. Fast forward to today: The inflation data only have come hotter, with a 9.1% higher than expected annual headline CPI reading for June. As of Friday, traders were pricing in a 31% chance of a 100 basis point move on July 27, a significant decline from Wednesday, and a 69% chance of a 75 basis point rise, according to the CME FedWatch Tool.

“The issue now is not about 100 basis points or 75 basis points: It’s how long inflation stays at these levels before it comes down,” said Jim Vogel, interest rate strategist at FHN Financial in Memphis. “The longer this goes on, the harder it will be to get any edge on risky assets. There are simply fewer upsides, which means it’s harder to recover from any round of selling.”

The absence of buyers and the abundance of sellers is causing gaps in bid and ask prices, and “it will be difficult for liquidity to improve given some misconceptions in the market, such as the notion that inflation can peak or continue business cycles when there is a ground war in Europe,” Vogel said by phone, referring to the Russian invasion of Ukraine.

Financial markets are fast-moving, forward-looking, and generally efficient at evaluating information. Interestingly, however, they have had a hard time shedding the optimistic view that inflation should decline. of June CPI data showed that inflation was broad based, with virtually all components stronger than inflation traders expected. And while many investors are counting on the drop in gasoline prices since mid-June to dampen July’s inflation, gasoline is only part of the equation: Gains in other categories could be enough to offset that and produce another impression. high. Inflation derivatives traders have been waiting to see three more with a CPI of 8% or more July, August and September readings, even after taking into account declines in gasoline prices and Fed rate hikes.

Before the Fed’s decision, “there are going to be asset dislocations, there’s no other way to put it,” said John Silvia, a former chief economist at Wells Fargo Securities. The stock market is the first place such dislocations have appeared because it has been more overvalued than other asset classes, and “there are not enough buyers at existing prices relative to sellers.” Credit markets are also seeing some pain, while Treasuries, the world’s most liquid market, are likely to be the last place to be hit, he said by phone.

“There’s a lack of liquidity in the market and gaps in bid and ask prices, and it’s not surprising to see why,” said Silvia, now founder and CEO of Dynamic Economic Strategy in Captiva Island, Florida. “We are having inflation that is so different from what the market expected that the positions of market players are significantly off. The market cannot adapt to this information so quickly.”

If the Fed decides to hike 100 basis points on July 27, taking the fed funds rate target to between 2.5% and 2.75% from a current level between 1.5% and 1.75%, “there will be a lot of losing positions and people on the wrong side of that trade,” he said. On the other hand, a 75 basis point hike would “disappoint” on fears that the Fed is not serious about inflation.

All three major US stock indices are racking up double-digit losses so far this year as inflation picks up. On Friday, Dow Industrials DJIA,
+2.15%,
S&P 500SPX,
+1.92%
and Nasdaq Composite COMP,
+1.79%
posted weekly losses of 0.2%, 0.9% and 1.6%, respectively, although each of them finished considerably higher for the day.

Over the past month, bond investors have oscillated between selling Treasuries in anticipation of higher rates and buying them out of fear of a recession. 10 and 30 years Treasury Yields they have each fallen three of the last four weeks amid renewed interest in public debt safety.

Long-term Treasuries are one part of the financial market where there has been “arguably less financial dislocation,” said Vogel’s New York-based economist Chris Low, a colleague at FHN Financial, despite a deeply inverted Treasury curve supporting the notion of economic downturn. Prospects and markets may be caught in a turbulent environment that lasts as long as the financial crisis and recession of 2007-2009.

Investors concerned about the direction of equity markets, while looking to avoid or cut cash and/or bond allocations, “can still participate in the upside potential of equity market returns and remove a predefined amount of risk to the down through options strategies. said Johan Grahn, vice president and head of ETF strategy at Allianz Investment Management in Minneapolis, which oversees $19.5 billion. “They can do this on their own or invest in ETFs that do it for them.”

Meanwhile, one of the defensive plays bond investors can make is what David Petrosinelli, a senior trader at InspereX in New York, describes as “barbelling,” or owning securitized and government debt in the shorter and larger chunks. Treasury curve longs: a “tried and true strategy in a rising rate environment,” he told MarketWatch.

Next week’s economic calendar is relatively light as Fed policymakers head into a lockdown period ahead of their next meeting.

Monday brings the NAHB Home Builders Index for July, followed by June data on building permits and housing starts on Tuesday.

The next day, a report on June Existing Home Sales will be released. Thursday’s data is comprised of weekly jobless claims, the Philadelphia Fed’s manufacturing index for July and leading economic indicators for June. And on Friday, the S&P Global US Manufacturing and Services Purchasing Managers’ Indices are released.

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