Inflation data sinks stocks on doubts Fed will deliver 3 rate cuts

By Vivien Lou Chen

‘The game-changing possibility is that the Fed would have to raise rates,’ said portfolio manager Phil Toews

Traders are growing increasingly anxious about the possibility that they, along with Federal Reserve policy makers, have underestimated the longevity of U.S. inflation – putting calls for three quarter-point interest-rate cuts this year in jeopardy.

Anxiety was seen in the government-bond market, where long-term Treasurys yields jumped by the most in a month on Thursday. The trigger for the selloff in government debt was February’s producer-price index, which rose by a hotter-than-expected 0.6%. Meanwhile, fed-funds futures traders continued to mostly cling to the likelihood of three Fed rate cuts by December – even as they gravitated slightly toward the prospect of just two – and still expected the first move to arrive by June.

For much of this week, starting with Tuesday’s consumer-price index report for last month, traders seemed willing to look past stubbornly persistent inflation above the Fed’s 2% target. But now sentiment seems to be shifting, with some in financial markets increasingly worried that calls for three quarter-point Fed rate cuts this year will turn out to be wrong.

“I’ve been saying for the last three months that the market has been perpetual optimistic for two-and-a-half years and, at every step along the way, has underestimated the Fed’s willingness to tighten,” said portfolio manager Phil Toews, chief executive of Toews Corp. in New York, which oversees $1 billion in assets. “The market is now being overly optimistic about the Fed’s ability to ease.

“People need to ask the question, ‘If we’re still overly optimistic, what are the implications?’ I think the implications are that we need to consider the possibility that the Fed stays parked with rates into the summer or needs to raise rates again,” Toews said via phone on Thursday.

Adding to the sense of worry unfolding within the financial market on Thursday are inflation dynamics overseas. Some analysts expect the Bank of Japan to exit its negative-rate policy and hike borrowing costs as soon as its next meeting on Monday and Tuesday, which has the potential to dent investor sentiment ahead of the Fed’s policy announcement on Wednesday. Growing demand for downside protection is being seen in options linked to the Secured Overnight Financing Rate on the view that the Fed will deliver fewer rate cuts than expected, according to Zhiwei Ren, managing director and portfolio manager at Penn Mutual Asset Management in Horsham, Pa., which oversees more than $34 billion in assets.

“Maybe the Fed was too optimistic about the inflation path and the risk is that we don’t see even one rate cut this year,” Ren said via phone.

Fed officials have left interest rates at between 5.25% and 5.5% – the highest levels in more than two decades – since last July, and have indicated that three quarter-point rate cuts are likely to be appropriate for this year. Traders are now in line with the Fed’s guidance, centering their expectations around the likelihood that the fed-funds rate target falls to between 4.5% and 4.75% by December.

Thursday’s selloff in bonds was accompanied by declines in all three major U.S. stock indexes. Dow industrials DJIA finished down by more than 130 points, or 0.4%. The S&P 500 SPX and Nasdaq Composite COMP fell by 0.3% each.

Despite their declines on Thursday, stocks are still broadly higher for the week and year to date, as investors and traders stuck by the view that strong economic growth despite persistent inflation can add up to good news.

For now, “the equity market could tolerate a parked Fed, but the bond market would realize further losses from here,” Toews said. “The game-changing possibility is that the Fed would have to raise rates. It’s a small possibility, but considering markets have been too optimistic about the Fed, it is something that should be contemplated in portfolios.

“Three rate cuts is hard to understand at the moment with this data,” he added. Historically speaking, past episodes of U.S. inflation have tended to last four to nine years on average, according to the portfolio manager.

-Vivien Lou Chen

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03-14-24 1658ET

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