Interest Rates Headed Higher

Major stock market averages opened sharply lower today after a key inflation report (see below). At the moment, the Dow is down 880 points and the S&P 500 is down 3%. All eleven market sectors are in the red, led by communications (-4.3%), consumer discretionary (-4%) and technology (-4%). The VIX Index, measuring fear among traders, popped to 25.9, but that’s not even as high as it was at the beginning of the month. That, combined with gold down 1% and safe-haven Treasuries down .5%, suggests no real panic among investors. Nobody is running for the exits, but it is fairly clear that the Fed will have to continue raising interest rates to cool inflation.

Today’s Consumer Price Index (CPI) report—for the month of August—was confusing and failed to convince investors that inflation is moderating. Headline CPI did decelerate to an annual rate of 8.3% from 8.5% in the prior month. But most economists expected something closer to 8%, and a lot of that downward progress was due to falling energy prices. Stripping out food & energy, Core CPI actually accelerated to 6.3% from 5.9%. In terms of year-over-year price growth, the biggest contributors were electricity (+15%), rent (+6.2%), and food (+11.4%), and health insurance (+24.3%). The US economy is proving very resilient in the face of high inflation, but the Federal Reserve is committed to slowing growth in order to bring inflation back to normal levels. Consequently, Bloomberg News says this report “likely assur[es] another historically large interest-rate hike” next week. I’ll go a step further and say this report will encourage the Fed to keep hiking rates well into 2023. While inflation clearly peaked last summer, it hasn’t moderated rapidly, or in a straight line.

In a recent interview, BMO’s Brian Belski lamented the market’s preoccupation with the magnitude of the Fed’s next rate hike (.5% or .75%). “We’re being way too short-sighted on this. We need to focus on double-digit earnings growth [and] still very low interest rates from a long-term perspective. An stop trying to time the market and call for all these near-term corrections.” In other words, don’t let discrete events like a single rate hike or election result distract attention from the long-term trend. “Be an investor.”

Optimism among small business leaders—as measured by the Nat’l Federation of Independent Business (NFIB)—improved more than expected in August. The proportion of survey respondents saying they expect worse business conditions over the next six months dropped to 42% (lowest since February). Inflationary pressures and shortage of labor are the main reasons for lower profits compared with a year ago. But inflation seems to be easing, and as a result fewer business leaders are planning price increases.