Despite 41-year high US inflation print, investors betting rate cuts are not far away

The 41-year high retail inflation print for June in the US, released on July 13, initially spooked investors in the global bond and equity market.

Consumer prices surged at the rate of 9.1 percent, which was sharply higher than economists’ expectations and further fueled market’s doubt that the US central bank has fallen extremely behind the curve in tackling runaway prices.

The reaction of the market was to quickly factor in the historic possibility of the US Federal Reserve raising interest rates by 100 basis points to 2.5-2.75 percent from the current 1.5-1.75 percent at its upcoming meeting later this month. A 1 basis point is equivalent to 0.01 percent.

"Everything is in play," Raphael Bostic, Atlanta Fed President told the media. “Today’s numbers suggest the trajectory is not moving in a positive way. How much I need to adapt is really the next question,” Bostic said, as per a Reuters report.

President Joseph Biden downplayed the number as he asserted that the data did not take into account the recent softening of retail fuel prices and was likely “out of date”.

Yet for investors, a full percentage point hike in interest rates in the US will have consequences not only the for the US economy but for the global economy as well due to impact on US imports if the economy tips into recession.

“Aggressive Fed (interest rate hikes) will push us into recession by year end,” said famed hedge fund manager Bill Ackman on twitter.

Currently, market participants are pricing in a 100 bps hike in July, a 75-basis point hike in September, and two 25-basis point hikes thereafter that will take the Fed fund futures to 3.75-4 percent by the end of the year.

The Fed’s own members expect interest rates to rise throughout this year and then remain flat for entirety of 2023 followed by some cuts in 2024. But, the market now believes that the Fed would be forced to cut rates as soon as March 2023.

As per the Fed fund futures watch by CME, traders are betting on the first 25 basis points cut in interest rates in March likely followed by another one by July 2023.

“The market appears to assume that the Fed will act as it did in the last three recessions by immediately easing when the economy goes into recession,” Ackman said.

The rebound in US stock market overnight after more than 2 percent cuts and the buoyancy in Asian markets today reflects that market expects the Fed to bring out the monetary policy bazooka much sooner than the central bank would like to.

At home, the Nifty 50 and BSE-Sensex index rose 0.4 percent mimicking their Asian peers.

Having said that, everything depends on how inflation evolves in the coming months given that it is also driven by supply side issues and rampant rise in global commodity prices. Commodity prices have crashed over the past few weeks, while hopes of China’s reopening from COVID-19 lockdowns should ease supply chain constraints.

In the past, interest rates have had to go above the prevalent inflation rate to have a meaningful impact on the latter. A scenario where the Fed will have to keep raising rates even as the US and global economy enters a recession is a nightmare for equity investors, as it will confirm one of the most dreaded economic conditions – stagflation.