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Inside the Broker - What will the Federal Reserve say about inflation?

Inside the Broker

What will the Federal Reserve say about inflation?

A quick look at the chart of any US stock index tells us a similar, and on the face of it, rather boring story. At least, that’s been the picture over the last month. As far as the US is concerned, the summer officially begins after the Independence Day holiday in early July and ends after Labour Day at the beginning of September. But it feels as if summer has started early this year with most investors content to sit back and let the markets do their thing, which currently looks like being very little.

Trudging up the hill

Following a sharp sell-off in early May, most of the major indices have managed to grind higher. But some have done better than others. For instance, the NASDAQ 100, which has a heavy weighting towards tech and growth stocks, is up 8% in the past month. The Russell 2000, which contains the stocks of smaller companies which tend to have domestically focused businesses, is up a solid 9.5%. The S&P 500 which comprises the stock prices of the largest 500 US companies by market capitalisation is up only 4.7%, albeit currently trading at its all-time high, while the Dow Jones Industrial Average, also known as ‘Old Wall Street’, has only managed a 3% gain over the sale period. What gives?

Inflation concerns

One explanation is the effect of interest rates, or more accurately, bond yields. This time last month there was an inflation scare following an unexpectedly large jump in the Consumer Price Index (CPI). Headline CPI hit its highest level since September 2008, during the Great Financial Crisis. Core CPI (which excludes food and energy) accelerated at its fastest rate since 1996, the last time that inflation was a serious issue for developed markets. Equities were already in decline when the news hit. But the selling accelerated as investors feared that the US Federal Reserve would be forced to tighten monetary policy sooner than previously expected.

Bond yields

But then a funny thing happened. Instead of shooting higher on the prospect of rate hikes, which would be the central bank’s expected response to a pick-up in inflation, bond yields (that is, ‘real world’ interest rates) started to come down. The yield on the key US 10-year Treasury note fell sharply. The reason? Well, bond investors decided that they agreed with the Federal Reserve when it came to higher inflation. They too believed that it would prove to be transitory. Not only that, but they also put their money where their mouths are. If inflation was to pull back over the rest of this year, there would be no reason for the US central bank to tighten monetary policy sooner than expected. After all, the US economic recovery is uneven, with unemployment still well above pre-pandemic levels. Members of the Federal Reserve’s FOMC (Federal Open Market Committee) have repeatedly stated that they want to see a substantial improvement in employment from current levels before they will tighten monetary policy.

Weak payroll numbers

Then we saw a disappointing Non-Farm Payroll report for May, a second one in a row. This lifted equity markets again, as it indicated that unemployment was still too high for the Federal Reserve to make a move. Then another unexpectedly large jump in CPI inflation last week saw stock indices rally again. Equities got a boost as the 10-year Treasury yield fell to 1.43% - its lowest reading since February this year and an astonishing 33 basis point decline in the space of 10 weeks. The lower interest rates go, the better it is for most equities, particularly for those tech and growth stocks in the NASDAQ which borrow now on the expectation of market growth later. In contrast, the banking sector does well when interest rates are rising as it makes more money on the spread between borrowers and lenders. There’s a heavy weighting of bank stocks in the old Dow which helps explain its underperformance relative to the NASDAQ.

FOMC forecasts

Now we have the Federal Reserve’s two-day FOMC meeting to consider. This ends on Wednesday and the general consensus is that there will be no change to monetary policy. Despite this, it’s an important one as, along with Chairman Powell’s press conference, it also includes the FOMC’s quarterly Summary of Economic Projections. The Summary gives each committee member the opportunity to give their predictions for inflation, interest rates, GDP growth and unemployment for the next two years and beyond. The Summary includes the infamous ‘dot plot’ which expresses each FOMC member’s forecast for the Fed Funds rate the world’s most important interest rate. There’s likely to be a lot of focus on this, and traders will be eyeing it eagerly to see if FOMC members remain dovish, or if the recent inflation spike has got some of them worried. Overall, the feeling is that there won’t be any rate hikes until 2023. But investors won’t like it if they see anyone on the FOMC forecasting an earlier move.

Smart News

To keep on top of everything that happens, from the FOMC’s forecasts to the latest economic data, make sure you keep a close eye on our Smart News widget. This is available to all Trade Nation live account holders and includes curated news feeds from social media designed to keep you one step ahead of the regular financial press. Not yet ready to take the leap to a live account yet. Well, why not give our practise-and-learn account a go?

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