This has been a rough week for the stock market.
Share prices have been dropping since Tuesday, when higher-than-expected Consumer Price Index (CPI) numbers sent shockwaves around Wall Street.
Traders have been adjusting their expectations for how aggressive they believe the Federal Reserve is going to be in raising interest rates to combat inflation. It still looks like most traders believe the Fed will only hike rates by 0.75% at its monetary policy meeting next week. But expectations for where the Fed will push the Federal Funds rate by the end of 2022 have risen from 4% to 4.5% during the past week.
The headline inflation number was actually quite reasonable; it showed that inflation for all items had only increased by 0.1% during the August – bringing the annualized rate to 8.3%. Falling gasoline prices helped keep this number lower.
The surprising news came with the core inflation number (all items less food and energy). It showed that prices for items other than gasoline and food had risen by 0.6% during August – bringing the annualized rate to 6.3% (see below).
(Source: Bureau of Labor Statistics)
Wall Street knows the Federal Reserve cares more about the core inflation number than it does about the headline number because the Fed doesn’t think it can have much impact on food and energy prices with its monetary policy.
That’s why traders reacted so swiftly to yesterday’s news and started selling stocks. They know higher inflation numbers are going to force the Fed to be more aggressive in their monetary policy response.
Before the BLS released the latest CPI data on Tuesday, most traders appeared to be expecting another rate hike of 0.75% in September. Fed Chair Jerome Powell had started to lay the groundwork for a third 0.75% rate hike in a row during his speech at Jackson Hole in late August and had been reiterating that message at every opportunity in the following weeks.
However, with the inflation numbers coming in so high, many traders are anticipating the Fed may be forced to raise rates by a full 1% at its next meeting. You can see this in the Target Rate Probabilities chart for September in Fig. 2. It shows that futures traders have already priced in a 30% chance of a 1% rate hike.
The current target rate is 2.25%-2.50%. Many traders expect the Fed to raise the target rate to 3.25%-3.50%.
If you look ahead to the Target Rate Probabilities chart for December in Fig. 3, you’ll see that it shows futures traders believe aggressive rate hikes are going to continue through the rest of the year and have priced in an 88.4% chance that the Federal Funds Rate have an upper range of 4.50% by the end of 2022.
You determine this percentage by adding the percentages of the various ranges together (10.1% + 37.3% + 41.0% = 88.4%).
This is a huge change in expectations. Just one week ago, traders were pricing in a 98.4% chance that the Fed wouldn’t raise rates above 4% by the end of 2022.
(Source: CME FedWatch Tool)
It may take some time for Wall Street to fully settle in to these new expectations.
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The Bottom Line
After selling all day on Tuesday, traders seem to be taking a break on Wednesday. As you can see in the chart of the S&P 500 (SPX) in Fig. 5, support is still holding just above 3,900.
We expect this level to hold in the near term. Traders don’t want to send the S&P 500 back down into bear-market territory if they don’t have to. We’ll be watching to see what they do from here.
John and Wade
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