As investors continue to digest Wednesday’s consumer-price index report for April, Jefferies, one of the more than two dozen primary dealers that trade directly with the New York Fed, is coming out with a relatively bold conclusion.
A pair of economists at the firm say April’s CPI “shows no evidence that inflation has really ‘peaked.’” They focus on the part of the report that reflects so-called “core” services — plus other recent data on wages and labor costs — which suggest the probability of a wage-price spiral is rising and now puts 75 basis point rate hikes on the table for the Federal Reserve at its next few meetings.
The analysis by Aneta Markowska and Thomas Simons stands out because financial markets appeared to initially take the CPI report in stride, given an annual headline inflation rate that slowed to 8.3% from 8.5% previously. If the vision laid out by Jefferies pans out, that would put into play a scenario that isn’t yet seriously being considered by investors: Jumbo-size U.S. rate hikes that haven’t been seen in almost 30 years.
What Jefferies is pointing out is that “this inflation is a heck of a lot more persistent than the Fed is discounting,” said John Silvia, founder and chief executive of Dynamic Economic Strategy in Captiva Island, Fla. “That creates a lot of uncertainties in the market, making it much more difficult for everyone.”
Markets have long been sensitive to the size of Fed rate moves, as well as the “announcement effect” of comments by policy makers, Silvia said via phone on Wednesday. Such an effect was on display last Wednesday when stock markets cheered Fed Chairman Jerome Powell’s remark that a 75 basis point hike wasn’t actively being considered. A similar dynamic was seen in January, when Powell declined to dismiss speculation that the Fed might raise rates at consecutive meetings, or hike in 50-basis-point increments — causing stocks to sell off.
“If some time in the next month or so, one of the Fed presidents or governors starts talking about 75 basis points, the S&P 500 would sell off by another 5% or 10% even before the Fed moves in June or July,” said Silvia, the former chief economist at Wells Fargo Securities. And the 10-year Treasury would also rise by another 40 basis points from its current level of just above 3%.
The focus of the Jefferies analysis is on the core measure of services, excluding energy services, which had a 0.7% monthly rise and is now at its highest since August 1990. In just one single category — transportation services — the monthly gain was 3.1%, up from 0% in December. Overall, core inflation, which excludes food and energy, accelerated to 0.6% on a monthly basis in April from 0.3% previously — putting the annual core reading above 6%.
Though the annual headline rate dropped to 8.3% from 8.5%, “the only reason y/y inflation slowed was base effects,” Markowska and Simons wrote in a note Wednesday. “There is no sign of a sequential slowdown in underlying price pressures.”
Reached by phone, Simons, a money market economist, said that “mathematically, it is the peak, with a very shallow slope. How fast are we getting down to a more normal level? The only way that happens with any speed is if the Fed moves into restrictive territory,” with the fed-funds rate target possibly moving into the 4% area from a current level of 0.75% to 1%.
Rhetoric around the notion of a possible 75 basis point hike or two, even before the Fed delivers them, “puts risks assets in a very precarious position,” Simons said. Fed officials would have to reverse course and “do a lot of talking” to get markets back on board with the idea. Meanwhile, bringing forward a 75 basis point rate hike in the markets would boost the perceived odds of a recession — leaving 10- and 30-year yields not that much higher from where they are now.
As of late Wednesday afternoon, Treasury yields moved mostly lower. The 10-year rate
dropped below 2.92% — shrinking its differential to the 2-year rate in a sign that bond investors may be more worried about the economic outlook.
Investors can be rattled by rhetoric about the size of Fed rate hikes because it triggers the prospects of more hikes to come, as well as the need to mark down future stock valuations and adjust one’s thinking about the path of inflation, said Silvia of Dynamic Economic Strategy.
“If I tell you the bill for dinner is $25 and give you a bill for $50, the bill you are getting to fight inflation is a lot more than you expected when you went into the restaurant,” Silvia said. “What markets would be reacting to is that the bill for fighting inflation is no longer 25 or 50 but could be 75 basis points, and idea we are not getting back to normal by the end of this year. I don’t think markets want to hear that.”