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Inside the Broker - Stock indices off highs as inflation bites again

Inside the Broker

Stock indices off highs as inflation bites again

All the major US indices rallied sharply on Friday in a session that brought fresh record closing highs for the Dow Jones Industrials, S&P 500, and NASDAQ 100. This was quite a reversal following the selloff seen during the previous day’s trade. As this week got underway, the major indices continued to grind higher with second quarter earnings season in focus. Goldman Sachs and JP Morgan beat the market’s consensus estimates for both earnings per share and revenues, boosting hopes for more good news from the banking sector. Citigroup, Morgan Stanley, Wells Fargo, and Bank of America also report this week. According to analysts at Refinitiv profits of companies in the S&P 500 are expected to rise 65% from this time last year when the pandemic was at its worst. If so, that would mark the strongest earnings growth since the fourth quarter of 2009, when stocks recovered from the global financial crisis.

Inflation running hot

Meanwhile, the US Consumer Price Index (CPI- the most important inflation measure for investors) came in hotter than expected. Headline CPI rose 0.9% month-on-month, significantly above the +0.5% expected, and the previous reading of +0.6%. The year-on-year data looks even worse, coming in at +5.4% against +4.9% expected and a prior reading of +5.0%. The data led to a sharp sell-off in stock indices and precious metals as the US dollar jumped. The data raises concerns that inflation may prove to be less transitory than the Federal Reserve currently calculates. It could also be used as a rod by policymakers to give Jerome Powell a thrashing. The Federal Reserve Chairman is in Washington on Wednesday and Thursday to testify on the Semi-Annual Monetary Policy Report. Friday sees the latest update for US Retail Sales.

Bond yields

Last week traders focused on the dramatic movement in bond yields. The yield on the key US 10-year Treasury note fell to 1.26%. Putting this into context, that represented a decline of 50 basis points from the highs hit three months ago, and a drop of 25 basis points over the last three weeks. Yields move inversely to bond prices, so the collapse in yield came as investors bought bonds aggressively. While this move was driven in part by a view that recent upside inflationary pressures will prove transitory, there is also a feeling that future economic growth could be lower than previously expected. But the speed of the fall in yields also reflected a slew of bond buying caused by short covering. It is understood that many hedge funds had recently sold bonds on the expectation of stronger-than-expected inflation. They were subsequently forced out of their positions as bond prices rose, sending yields to their lowest levels since February this year.

Contrarian China

Some of Friday’s rally in equities was down to the People’s Bank of China. The Chinese central bank cut its reserve requirement ratio. In essence, this makes it easier for banks to lend more money, in this instance by around $154 billion. As the rest of the world’s major central banks are either tightening, or actively considering tightening, monetary policy, China’s stance is rather unnerving. What does it say about their economic outlook? But a closer analysis suggests that the Chinese authorities are anxious to shore up some fragile parts of the Chinese financial structure, specifically heavily indebted companies. Of course, China has the luxury to make cuts to help troubled companies. The developed world used up its rate-cutting ammunition many years ago. All it can do now is buy up ever more financial assets.

Smart News

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