It’s been a hell of a week in the markets and a great Thursday for volatility. Consumer inflation beat expectations again in the United States, reaching its highest level since 1982 at 7.5%. This caused panic from at least one Fed official and investors stepped up their bets on a rate hike. The result? Yields soared and expensive tech stocks sent Wall Street crashing. But as of this writing on Friday morning, falling buying has seen major US indices rebound. It remains to be seen if the Bulls will be able to hold their ground, given the events of Thursday.
How high will the returns go?
At just over 2.0%, the 10-year rate is well below the inflation rate of 7.5%. This means that the actual returns are actually -5.5%. It’s weird to say the least. The Fed’s QE programs and strong foreign demand for US debt are the main reasons for this lag. The question is, why aren’t the yields higher? Is it because the market anticipates a drop in nominal inflation rates, and quickly? May be. Even if inflation fell back to around 3%, real returns would still be negative. It is therefore reasonable to expect returns to catch up with inflation. I think we will be heading for 3.00% over 10 years in the coming weeks, the speed of which will depend on incoming data and whether more Fed officials become as hawkish as Bullard. This should keep technology stocks under pressure, but support financials.
How many rate hikes?
The strong CPI print was a game changer on Thursday. The market is now looking at about 7 rate hikes of 25 basis points each, starting in March. Chances are, however, that we will see a 50 basis point rally in March, judging by rate futures and bullard commentary. If the Fed is worried about the economy falling into a wage-price spiral, we may even see further increases. But it all depends on the incoming data.
Main Economic Highlights
In the week ahead, there won’t be a whole lot of US macro pointers or Fed speeches, although we still have minutes from the PPI and FOMC meetings to look forward to. The key question is what will happen to yields, which of course will have implications for other financial markets, including US technology stocks. It is possible that if we see a stronger than expected PPI print, it will lead to more strength in yields.
Here are the week’s data highlights:
- Average earnings and jobless claims in the UK
- Quarterly estimates of the evolution of GDP and employment in the euro zone; German ZEW Economic Sentiment
- US PPI and Empire State Manufacturing Index
- CPI estimates from China, UK and Canada
- U.S. Retail Sales, Industrial Production, and FOMC Meeting Minutes
- Australia employment data
- FedSpeak: Bullard and Mester, members of the FOMC
- UK and Canada retail sales data
- FedSpeak: Waller and Williams, members of the FOMC
Chart to watch: 10-year bond yields
Source: ThinkMarkets and TradingView.com
Obviously, all the focus will be on the 10-year yields after breaking through the 2.00% barrier. How far will it go and how quickly will it have ramifications for the rest of the financial markets.