Markets expect the Fed will now be more willing to risk recession to fight hot inflation

Published Fri, Jun 10 202211:35 AM EDTUpdated Fri, Jun 10 20228:14 PM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

Some market pros believe the Federal Reserve may be more willing to risk recession with accelerated interest rate hikes after May's hot inflation report. Many economists had expected last month's inflation numbers would be part of a downslope, with headline inflation at 8.3%, matching April's number before sliding through the summer. But instead, the consumer price index flared hotter — to 8.6% year over year. That marked a 40-year high and raised new questions around the timing of the peak and what the Fed will do about it. "This is what people are going to worry about — 50-basis point rate hikes as far as the eye can see, unless the numbers change," said Jim Caron, chief fixed income strategist on the global fixed income team at Morgan Stanley Investment Management. He said investors could even begin to expect a 75 basis point hike if inflation doesn't cool soon. A basis point equals 0.01%. Shortly after the inflation report, Goldman Sachs economists issued a new forecast with a 50 basis point rate hike expected for September, in addition to half-point increases this month and in July. A more aggressive path ahead? Caron said investors may now expect policymakers to be more willing to follow a path recommended by St. Louis Fed President James Bullard . "He said get to 3.5% as fast as possible, and then we'll talk," Caron said. The fed funds rate is currently at 0.83%. "The first implication is if the Fed's going to be that aggressive, then the possibility of recession in 2023 rises," Caron said. "You're seeing the yield curve today flatten dramatically, and people are going to start looking for inversion." When shorter duration Treasury yields rise above the longer duration yields, that is an inversion and is viewed as a recession warning. "My view is they're willing to risk a recession. They were willing to risk it before, but this now seems like they're going to increase the risk," Caron said of the central bank. The yield curve and recession risk Stocks fell hard after the CPI report and took another leg down after a 10 a.m. ET report showed consumer sentiment at its lowest reading ever at 50.2. Economists surveyed by Dow Jones had expected May's headline inflation to rise by 0.7% on a monthly basis, but CPI jumped by 1%. Excluding food and energy prices, core CPI was up 6% year over year, slightly higher than the 5.9% estimate. The S & P 500 was down 2.6%, below the psychological 4,000 level around 12:30 p.m. ET. Treasury yields were higher. Market pros were watching the yield curve flatten , a negative warning for the economy. That was apparent as the 2-year yield leapt as high as 3%, while the 10-year traded at about 3.14%. The Fed first raised its fed funds target rate by 25 basis points in March, and then by another 50 basis points in May. Fed watchers have been expecting half-point hikes at next week's meeting and again in July, but September's forecast had been more cloudy. "I think what the market is going to focus on is what are the implications for the Fed, not so much this month or July, but September. That's what people are all fired up about," said Wells Fargo's Michael Schumacher. After the CPI, the futures market began to price a 92% chance of a 50 basis point rate hike in September, and a bigger chance of a 50 basis point increase for November, he said. Schumacher said the market was also pricing a peak in the fed funds at 3.50% by June 2023. But he added that after that peak, the market was pricing in 40 basis points of cuts. The forecast for rate cuts would be based on the assumption the Fed would ease because of a recession. He said more investors believe the Fed is willing to risk a recession, and that is clear in the futures market. "That's pricing in a bigger chance of Fed easing, so I would flip that around and say a greater chance of recession, but it's not a really big recession," he said.

U.S. Federal Reserve Board Chairman Jerome Powell speaks during his re-nominations hearing of the Senate Banking, Housing and Urban Affairs Committee on Capitol Hill, in Washington, U.S., January 11, 2022.

Graeme Jennings | Reuters