Markets call it right on inflation

As we start a new trading day in the US, the big news is the much stronger US inflation report for April and the associated surge in US Treasury yields. The inflation report for April showed that consumer prices surged to 4.2% growth per year, up from 2.6% at the end of March. This is the highest level since summer 2008. The key driver of prices: autos, which jumped at a 10% rate in April compared with March, which is the highest monthly gain in auto prices on record. When the price of cars and houses are rising together it means one thing: strong levels of consumer confidence. These big-ticket consumer items are bought when people are confident about the economic outlook and their own economic prospects. Today’s data leaves us with two important questions that could determine our trading decisions for the long term: firstly, last month’s weaker than expected jobs report was likely to be a blip, and secondly, what will the Fed do next?

Treasury yields to reflect market battle with Fed

The latter question is undoubtedly more important for financial markets in the short term. The immediate market reaction to the price data was felt in the bond markets. The 10-year US Treasury yield jumped 5 basis points after the data release, the 5-year yield, which is closely correlated to interest rate expectations, also rose by 5 basis points. The upward shift in yields along the Treasury curve may be the market’s latest attempt to price in a faster rate of interest rate tightening in the US than the Fed is currently signalling. In Q1 of this year, Treasury yields surged causing stocks to weaken and volatility to rise. Risk sentiment does not like it when the Fed and market expectations are out of synch. As we moved into Q2, the market came back around to the Fed’s way of thinking, that inflation will be temporary, and policy should remain lose to support the US economy’s ongoing recovery from Covid. However, when consumer prices are rising at 4.2% per annum, more than double the Fed’s traditional target rate, the market starts to worry. This is why we expect weak risk sentiment on Wednesday and for the Nasdaq to struggle to make gains; price fears are also likely to dent risk sentiment in other sectors including those that benefit from the economic recovery, such as energy and materials and consumer stocks. Financials could be protected from a sharp sell-off in the coming days, as rising interest rates can be beneficial for banks’ profitability.

Inflation report could leave Fed tongue-tied

The price rises in the US are broad. There are global chip shortages, and many companies have noted that they face higher costs for crops, oil and truckers’ wages. Not only are component costs rising, but so too are the costs of transporting goods around the country. Companies listed on the Dow and S&P 500 stated in their Q1 earnings reports that they intend to pass price rises onto consumers, thus pressures are building throughout the inflation pipeline. When this happens, it is hard to see how inflation will be temporary, and we could be in for another period when the market questions the Fed’s judgement and starts pricing in for an earlier rate rise.

Deciphering the Fed

The market impact of the stronger than expected inflation data from the US has so far been felt in the bond market, as we mentioned above. At the time of writing, 5 and 10-year Treasury yields continue to inch higher ahead of the US market open. E-mini S&P 500 futures are expecting the main US market to open lower, and we believe that a continued uptick in Treasury yields in the coming days could keep all sectors of the US market, in particular consumer stocks and tech, on the backfoot as we move into the second half of this week. Watch out for any speeches from Fed members, a sign that the US central bank could move to a less dovish position on the back of this inflation data could send markets into a tailspin. However, we expect markets to remain in a high state of agitation even if the Fed comes out and tries to talk down the price increases for April – the trouble with that line of defence from the Fed is that it ultimately increases policy uncertainty, as the Fed may have to backtrack at some stage. Considering the markets like to price in what will happen 6-months in the future, rising price pressures now means that the market is guessing where policy will be in the next 6-months. If we see the 5-year Treasury yield cross the 0.9% mark in the next day or so, then it indicates that the market believes a faster pace of Fed tightening is on the cards.

What rising prices means for financial assets

The dollar index has remained fairly flat on the back of today’s data. We have noted in the past that the dollar’s relationship with Treasury yields is not always linear. However, at some point the dollar will start to rise, particularly if we see more strong inflation reports throughout the summer months. We continue to be GBP bulls. The stronger UK GDP reading for March, has negated the impact from the UK’s Q1 GDP contraction of 1.5%, which is not bad considering the country was in a strict lockdown. Added to this, the March budget expected GDP to rise at a 4% rate this year. The Bank of England’s growth update last week to more than 7% GDP growth for 2021 means that the UK Treasury has an extra £20bn growth windfall to play with. This could mean extra public spending, and thus more GDP upside, alternatively, it could keep tax rises at bay for the foreseeable future, which is good news for the FTSE. We continue to be bullish UK assets, and we believe that this week’s dip in UK stock prices could be seen as a good buying opportunity and the FTSE 250, in particular, could return to record highs in the coming days.