Market Extra: Why a single U.S. inflation report roiled global financial markets — and what comes next

The policy-sensitive 2-year Treasury yield, tied to the expected near-term path of Federal Reserve policy, traded at its highest level in almost 15 years — driven largely by expectations on how high the U.S. central bank could end up taking interest rates. And the greenback — often tied to the trajectory of U.S. interest rates relative to the rest of the world — remained close to 20-year highs, as measured by the ICE U.S. Dollar Index
DXY,
-0.15%.

The continued fallout from the CPI report underscores how badly misplaced global financial market participants were in thinking that U.S. inflation could meaningfully ease quickly, analysts said.

It wasn’t the slight decline in the headline annual rate, to 8.3%, that grabbed the most attention; rather, investors focused on, among other things, the smaller monthly read that strips out energy and food, which doubled to 0.6% from 0.3% the prior month.

Traders began factoring in a decent chance of a jumbo-size 100 basis point rate hike by the Federal Reserve next week, but were just as concerned about where rates might end up: Firms like PIMCO and Jefferies have flagged the possibility of a greater-than-expected 4.5% fed funds rate target, which is currently between 2.25% and 2.5%.

Read: ‘Peak inflation’ is dead. Here’s what that means for stocks

“All of the hopefulness of the prior month’s inflation reports was dashed — not just slightly, but by double,” said Will Compernolle, a New York-based economist for FHN Financial, referring to the size of the shift in August’s monthly core CPI gauge. “Before Tuesday, there was confidence that as bad as things were, they weren’t likely to get much worse and people had been pricing in certain improvement for inflation and the trajectory of the Fed.”

“The data shakes confidence in how bad things were and how bad they could get,” he said via phone on Wednesday. “It reverberated around the world because so many countries are on edge from their own inflation problems, which are largely tied to rising energy costs and priced in dollars. And worsening U.S. inflation that leads to tighter Fed policy causes the dollar to appreciate and accelerates the energy crisis for other countries.”

See: Why an epic U.S. dollar rally could be a ‘wrecking ball’ for financial markets

Even worse still is the speed with which U.S. policy makers are prepared to go in order to clamp down on the hottest inflationary fire of the past four decades. On Aug. 26, Federal Reserve Chairman Jerome Powell delivered a blunt message at the central bank’s Jackson Hole retreat that the Fed will keep trying to bring inflation down until the job is done, and that higher rates will bring “some pain to households and businesses.” Dow industrials closed down by more than 1,000 points the same day, and all three major U.S. indexes ended that week with losses.

Tuesday’s sharp U.S. selloff in equities was the second time in less than three weeks that stock investors had been so badly burned in a single day. U.S. stocks consolidated in choppy trade Wednesday, ending slightly higher as traders and investors weighed what might come next.

“We could get to a 4% fed funds so quickly, compared with recent historical episodes, that it’s hard to tell how the world will adjust,” FHN Financial’s Compernolle told MarketWatch. “When you put energy costs in emerging markets together with a lot of dollar-denominated debt, what a 4.5% fed funds rate does to those sources of distress is not clear. It’s hard to see that nothing breaks — whether it’s U.S. housing, political unrest in countries with existing energy crises, you have to think something will break.”

Related: A surging U.S. dollar is already sending ‘danger signals,’ economists warn

Buried inside the August CPI report were fresh signs of just how broad-based inflation has continued to become, despite an annual headline rate that fell to 8.3% from 8.5% in July: In particular, price gains for a swath of services showed no signs of any letup.

The CPI report “was a sign that inflation is more entrenched than people expected it to be at this point, despite the U.S. economy clearly slowing,” said Mark Heppenstall, chief investment officer of Penn Mutual Asset Management, which manages more than $30 billion from Horsham, Pa. “We still haven’t seen a meaningful turn in inflation, and the core number in particular had to be troubling for the Fed. The expectation was that inflation would turn quickly and sharply and yesterday’s number was a reality check.”

Read: Falling gas prices gave Americans false confidence that inflation was cooling at a faster rate. August figures disappointed analysts, Wall Street — and consumers.

“To the extent that inflation has become more entrenched, that will cause an immediate re-evaluation in how much risk people can take, especially with growth companies where the discounted rate on future earnings is more impactful,” he said via phone. Meanwhile, Heppenstall said, Penn Mutual has found attractive new investment opportunities in short to intermediate duration fixed-income assets recently.

On Wednesday, Japan’s Nikkei 225
NIK,
-2.78%,
China’s Shanghai Composite Index
SHCOMP,
-0.80%,
and Hong Kong’s Hang Seng Index
HSI,
-2.48%
notched their biggest one-day drops of the past three weeks to three months. Stock indexes from the U.K., Germany, Spain to the Netherlands, Switzerland and Stockholm also suffered declines. And the yield on the 10-year gilt BX:TMBMKGB-10Y, the U.K. counterpart to Treasurys, touched a 10-year high earlier in the day as investors sold off bonds, the asset class hit hardest by inflation.

Tuesday’s steep U.S. equities selloff wiped $1.5 trillion of value from the S&P 500, according to FactSet. The plunge in equities was said to have been exacerbated by institution traders and others who exited from big leveraged bets, via the options market, that inflation would cool.

“Many people were caught on the wrong side of Tuesday’s CPI report,” said Angelo Kourkafas, an investment strategist at Edward Jones in St. Louis. “It was the combination of upward surprise and positioning that resulted in an outsized selloff in the U.S.”

Continued Fed rate hikes “clearly raise the risk of recession and more volatility in stocks, with the chance we still could revisit June’s lows,” he told MarketWatch via phone. “From an investment standpoint, we expect more short-term volatility, some upward pressure on bond yields and potentially some weakness in the growth segments of the market.”

Soon after August’s CPI, the U.S. bond market began to price in at least a 4.5% terminal fed funds rate, extending the Fed’s rate-hiking cycle into the first quarter of 2023, said Neil Azous, chief investment officer of Rareview Capital in Las Vegas, an investment adviser and ETF sponsor with more than $150 million in assets under management. That compares with a 4% terminal rate by December that had been expected before Tuesday’s data release, he said.

Separately, the 5-year real, or inflation-adjusted, rate — as measured on Treasury inflation-protected securities — jumped above 1% on Tuesday to its highest level since December 2018, according to Tradeweb data. Historically, whenever real interest rates rise above 1%, “two bad things happen: the credit markets begin to clog-up and the S&P 500 multiple contracts,” Azous said.