Here are 4 reasons why market volatility is unlikely to subside anytime soon, even after the US inflation rate drops to 8.3%

The list of reasons why financial market swings may continue and even worsen grows daily, starting with the fact that investors are not yet pricing in worst-case scenarios for inflation and the US economy.

Although Wednesday’s consumer price index report showed the US annual headline inflation rate slowed to 8.3% in April, the data doesn’t entirely settle the question of where inflation is likely to go. inflation from here. Additionally, stock market investors have yet to price in a recession, with DataTrek co-founder Nick Colas saying the S&P 500 would need to fall to 3,525 from its current level, just above 4,000, to reflect a probability of a downturn. 50:50 of a recession. US recession

Financial conditions tightened so much earlier this week, days after the Federal Reserve unveiled the biggest rate hike in nearly 22 years, that markets were behaving as if the Fed’s main policy rate was already at 2.5%. , according to strategists at BMO Capital Markets. , although the target range is actually only 0.75% to 1%.

That’s significant because, in theory, it would take months for the Fed to get to 2.5%; Investors, meanwhile, will likely endure more volatility like last Thursday’s session, in which the Dow Industrials fell nearly 1,100 points on the day after rising more than 900 points.

Below are some of the reasons why last week’s volatility may continue and possibly increase in the coming months:

Inflation may have more room to run

Economists and traders are relying heavily on the word “peaked” right now. That’s because the prevailing view among professional forecasters is that inflation has already reached, or is close to reaching, its highest possible level. The inflation rate over the past year fell to 8.3% from 8.5% in March, the first drop in eight months.

Watch: Goldman’s Hatzius calls for peak inflation as firm cuts core forecast

But diffusion indices developed by TD Securities show strong bullish momentum behind inflation in the US, UK, Canada and the eurozone, leaving central banks likely “too optimistic” that will drop back to targets, according to a note this week. by James Rossiter, director of global macro strategy.

“Expectations point to a broader trend towards a gradual decline in inflation over the rest of the year,” said Subadra Rajappa, head of US rates strategy at Société Générale. “The key risk is that the market doesn’t know what it doesn’t know and we are heading into very, very volatile conditions.”

“Uncertainty about inflation outcomes is what really drives the markets. Do I generally expect more volatility? Yes,” she said by phone on Tuesday.

Inflation has already proven to be more durable than many expected and, historically speaking, it is difficult to put back in the bottle once it is unleashed.

During the first half of the 1970s, while the US was still engaged in the Vietnam War, the main annual rate of the consumer price index soared above 10% for more than a year under then-president of the Federal Reserve, Arthur Burns. Although Burns carried the fed funds rate above 10% for some of this time, according to FactSet data, that did not eliminate the need for his predecessor, Paul Volcker, to push rates back into double digits in the end. of the decade. when inflation climbed back above 10%.

Watch: Sharp swings in stocks and bonds offer a sign of more volatility to come given the risk that US inflation continues to rise

Read: Opinion: The ghost of Arthur Burns haunts a complacent Fed that adds fuel to the fire of inflation

75 basis points, on or off the table?

When Fed Chairman Jerome Powell said last Wednesday that policymakers were not actively considering a whopping 75 basis point hike, investors celebrated. But the positive sentiment did not last long. The next day, pessimism about stagflation risks took hold, sending stock markets into a tailspin.

Then, in a podcast posted on Friday, Richmond Fed President Tom Barkin told Market News International that he would not rule out a 75 basis point move. His colleague, Cleveland Fed President Loretta Mester, supported that view to some extent on Tuesday, when she said the Fed isn’t ruling out 75-basis-point moves forever, but the current pace of 50-basis-point hikes seemed “correct”. At the moment.

The Federal Reserve hasn’t raised 75 basis points since November 1994. Many active traders have never seen such a large interest rate hike in one go during their entire careers.

Just like 2019, only it’s not

By the time the S&P 500 SPX,
+0.46%
closed below 4,000 for the first time in 13 months on Monday, financial conditions had tightened so much that, excluding the early stages of the pandemic, they were at levels comparable to 2019, when the upper end of the fed funds target rate was 2.5%, according to BMO Capital Markets strategists Ian Lyngen and Ben Jeffery.

“The market continues to accelerate through the ‘price’ milestones of this cycle in a way that has us increasingly nervous that this will not end well,” they said in a note published before markets opened in New York on Tuesday.

The Federal Open Market Committee that sets rates “will continue to go higher until something breaks,” they said. “Needless to say, stocks down 16% year to date is not enough for the Fed to change its stance. 35% could trigger a different conversation among policymakers.”

Let’s be realistic about real rates

Real, or inflation-adjusted, rates have moved aggressively to the highest or least negative levels in two years. Since Tuesday, the 5-year rate on Treasury Inflation-Protected Securities has been in and out of positive territory: it was minus 0.019% on Wednesday morning versus minus 0.018% on Tuesday, according to Tradeweb. The 10-year TIPS rate was at 0.339% and the 30-year TIPS rate was at 0.704%, not far from where they finished on Tuesday.

Investors watch real rates carefully because they tend to reflect the true cost of capital for corporations, and an uncontrollable rise would likely hit stocks hard.

While the fixed income team at UBS UBS,
+1.36%
says most of the tightening in real rates is over, David Lefkowitz at the firm’s wealth management division and others said “we can’t rule out further hikes in real rates as the Fed tries to rein in inflation.”

“In our base case, we believe the economy will avoid a recession. In that scenario, stocks should recoup most of their year-to-date losses. However, our conviction in the base case is not high.”

— Christine Idzelis contributed to this article.

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