Hot Hot Hot

02.11.2022: The January reading on consumer prices surged more than expected, sending the annual inflation rate to a fresh four-decade high and adding more urgency to the Federal Reserve’s impending rate hiking program.  CPI expanded 7.5% over the last 12 months following a 7% year over year gain in December, according to Bureau of Labor Statistics. The widely followed inflation gauge rose 0.6% in January from a month earlier, reflecting higher food, electricity and housing costs.  Economists anticipated a 0.4% monthly price gain.

The news prompted investors to turn their attention to the Fed.  Fed fund futures now imply six, quarter-point rate hikes this year, with a growing chorus for a half-point move as early as next month.  Several Fed officials have suggested that an acceleration of inflation on the heels of rapid wage gains will keep the possibility of a half-point hike on the table.  The swap market projects an 80% chance of a half-point hike in March, and a high likelihood of one full percentage points higher over the next three central-bank gatherings, according to Bloomberg.

Meanwhile, the bond market slumped under the strain of higher inflation readings and tough talk from several Fed officials.  Two-year yields rose more than 0.2% to 1.5% in reaction, its highest single-day jump in nearly a decade.  10-year note yields broke through 2% for the first time since 2019.  Pay attention to the 10-year.  The benchmark Treasury is a critical component of equity market valuation.  Higher yields squeeze equity market valuations.

Yesterday’s rate spike weighed on equity markets, with growth-oriented sectors, like technology, leading the averages lower.  Cyclicals, those sectors most closely correlated to economic activity, fared relatively better. Equity earnings yield, the reciprocal of the PE ratio, ebbs and flows with interest rates.  Higher rates push earnings yields higher and PE ratios lower.  However, based on the shape of the yield curve, bond investors project the 10-year Treasury rate peaking at 2.3%, only 0.3% higher than today’s rate, suggesting that higher short-term rates will quickly dampen economic growth and inflation, sending trend growth back toward pre-pandemic levels.  If the bond market is correct, that means most of the equity market pain and suffering is behind us.  In the meantime, we will continue to watch the bond market for interest rates cues and credit conditions.  We stand ready to reduce risk if either of those metrics deteriorate.