Resetting Interest Rate Expectations

Both stocks and bonds opened higher this morning after falling more than 1% in yesterday’s session. A hotter-than-expected inflation report has traders reconsidering their exuberance (see below).

Inflation picked up a bit more than expected last month according to the Bureau of Labor Statistics (BLS). The Consumer Price Index (CPI) rose .3% in January from the prior month, and 3.1% from a year ago. Those numbers aren’t a disaster for the economy, but traders clearly expected them to be slightly lower.

This poses an immediate problem for the bond market, and to a lesser extent, the stock market. Why? Short-term traders took bond & stock prices higher in anticipation that the Fed will begin aggressively lowering interest rates as early as next month. They pushed that bet too far. This CPI report strongly suggests inflation isn’t falling fast enough to justify rate cuts over the next couple of months. So the resulting reset in expectations let some air out of the market’s sails yesterday.

Here again is a shining example of how wrong bond traders have been over the past couple of years; that is, too eager to gamble on the odds of individual rate hikes or cuts, and not eager enough to actually listen to what the Fed is saying. Fed officials have expressed a clear desire to be patient and methodical in assessing economic trends and interest rate policy. In December they tentatively predicted three .25% interest rate cuts in 2024. So for bond traders to build-in the expectation for six rate cuts was just folly. In the aftermath of the CPI announcement, traders seem sobered.

Yesterday’s hand-wringing aside, the broad trend still points to slowing inflation and lower interest rates…at some point in 2024. For longer-term investors, the broad outlook remains unchanged.