Why horror US inflation data panicked markets
But worse – much worse – was the reading for core inflation; the predicted 0.3 per cent rise actually came in twice as high at 0.6 per cent, with the annual pace of change surging from 5.9 per cent to 6.1 per cent.
Cue panic across markets, or something very close to it.
The Dow Jones Industrial Average fell 3.9 per cent to post its worst day since June 2020. The S&P 500 dropped 4.3 per cent. And the Nasdaq Composite Index was the biggest loser, plunging 5.2 per cent in its worst day since March 2020, when the pandemic panic was in full swing. Every single stock in the Nasdaq 100 finished in the red.
The ASX opened with a bang too, with the benchmark ASX 200 down 2.7 per cent in morning trade. Every stock in the index except Computershare was in the red.
Arguably, the more interesting action was on bond markets, where the reality that the US Federal Reserve is going to have to take interest rates higher than expected to tame inflation quickly set in.
Two-year US Treasuries jumped as much as 0.22 of a percentage point, while the bond market’s prediction of the Fed’s terminal rate – that is, the highest point it will take rates to in this cycle – jumped to just below 4.33 per cent in April, 2023.
Shock to the system
Perhaps most remarkably, the odds of the Fed delivering a super-sized 1 per cent rate rise leapt to 47 per cent at one point on Tuesday night, although this has retreated.
So, what exactly spooked the market so badly?
Unlike previous CPI shocks, where the numbers for used car prices or rents have put a scare through investors, there was not one data point that traders could grab on to; perhaps except for health insurance, which surged 2.4 per cent in a month and is running at 24.3 per cent on an annual basis.
Rather, what shocked the market was heat in the economy across the board. Yes, petrol prices fell 10 per cent as expected. But the signs of cooling in goods prices that markets have welcomed recently are simply not showing up in the CPI data. And services – particularly shelter, healthcare and transportation – are continuing to rise.
Seema Shah, chief global strategist at Principal Global Investors, says it is likely that headline inflation has peaked, as had largely been expected. But the problem for the Federal Reserve is core inflation, which includes the most sticky items.
Indeed, the Atlanta Federal Reserve’s CPI measure that tracks so-called sticky inflation – rent, baby clothes, alcohol, car insurance, furniture, medical costs – rose 6.1 per cent in August from a year ago, the biggest gain in 40 years.
Although Fed chairman Jerome Powell has told everyone who would listen that he would not rest until inflation was clearly on the way back down towards the central bank’s 2 per cent inflation target, investors were becoming increasingly confident that the twin peaks that matter for equities – inflation and official US interest rates – were visible on the horizon.
But Tuesday night’s numbers simply don’t support that optimism.
“In fact, 70 per cent of the CPI basket is seeing an annualised price rise of more than 4 per cent month-on-month,” Shah says. “Until the Fed can tame that beast, there is simply no room for a discussion on pivots or pauses.”
No pivots or pauses to rate rises
And what will it take to tame that beast? The Fed needs to cool an economy that is still running hot by raising rates and keeping them higher for longer than the market might have otherwise expected.
In the coming days, the market will endlessly debate whether the Fed needs to raise rates by 0.75 of a percentage point or 1 percentage point after this CPI print, and whether the terminal rate now sits above 4 per cent or even higher.
This is all great theatre, but it also risks missing the key lesson out of Tuesday night’s shock: we’re not going back to the pre-COVID-19 days of low inflation, low interest rates and seemingly endless central bank support for markets.
Investors have been far too optimistic about the potential for the Fed to pivot back towards rate cuts, or at least a pause in increases, at the first signs of a cooling in inflation and damage to the US economy.
What has so shocked the market about these latest CPI numbers is that the Fed hasn’t even started the task of bringing inflation back towards 2 per cent – core inflation is still rising, and it’s now uncertain when it will actually start to fall.
Market’s biggest mistake
Taming inflation is going to take patience, persistence and pain for the Fed and global markets.
For example, it’s hard to see how inflation doesn’t fall without unemployment jumping and the US economy slowing down markedly. Lower petrol prices alone won’t change the game because the very healthy US consumer is simply taking their fuel bill savings and spending them elsewhere.
The hard landing clearly remains in play after this inflation shock.
Investors too have to steel themselves for a regime change. On Monday, at the famous SALT hedge fund conference in New York, Bridgewater Associates co-chief investor Greg Jensen warned investors were overestimating the Fed’s ability to bring inflation down quickly, creating the risk of a deep, broad and lengthy recession. His core message was one of regime change in markets.
“I think the biggest mistake right now is the belief we’re going to return to essentially prices similar to pre-COVID,” he said.
Wei Li, global chief investment strategist at the BlackRock Investment Institute, agrees, arguing that the so-called “great moderation” – that long period of steady growth and low inflation we had before COVID-19 – is being replaced by a more inflationary world with “macro and market volatility reverberating through the new regime”.
Sky-high debt levels will give central banks less room to manoeuvre, BlackRock says. “And the politicisation of everything makes simple solutions elusive when they’re needed the most. This leads to bad outcomes.
“We expect higher risk premia for both equities and bonds – so investment decisions and horizons must adapt more quickly. Traditional portfolios, hedges and risk models won’t work any more.”
One final thing to consider on the US inflation shock is whether there are parallels we should draw with our own situation in Australia.
Reserve Bank governor Philip Lowe has regularly talked about how different the US and Australian economies are, but this inflation shock should lead local economists and investors to consider whether their predictions of a coming peak in Australian inflation and interest rates are as solid as they thought at the start of the week.
Might consumers here prove as resilient as US consumers, given the Australian labour market remains similarly strong? And might inflation here also prove stickier than we thought?