Market Extra: ‘Peak inflation’ trade is driving financial markets as investors brace for U.S. economic slowdown

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Financial markets are increasingly trading on what Deutsche Bank describes as “a ‘peak inflation’ world view” — one that would entail a less aggressive response from the Federal Reserve than previously feared, even though inflation has yet to show signs of demonstratively peaking.

The idea being broadly embraced for now is that an impending U.S. economic slowdown and/or recession is likely to cure the problem of persistently high inflation over time. It’s just the latest way in which ordinarily optimistic, forward-looking markets are trying to focus on the brighter side of things ahead of the Fed’s policy meeting next Tuesday and Wednesday.

While an outright recession usually takes months to be declared by the only arbiter that matters, the National Bureau of Economic Research, traders and investors are wasting no time drawing their own conclusions. In a nutshell, they see an anticipated falloff in growth in the world’s largest economy as equaling a falloff in hot inflation at some point.

That thesis is reflected in inflation breakeven rates trending between 2.18% and 2.6% as of Friday, plus a notable drop in yields on 5-, 10- and 30-year Treasury inflation-protected securities over the last few days, according to Tradeweb data. In addition, most Treasury yields fell below 3%, while fed funds futures are trading at levels which imply Fed officials could back off of a 75-basis-point rate hike in favor of a smaller 50-basis-point move in September.

Meanwhile, inflation-derivatives traders see the annual CPI rate falling to as little as 2.5% next June, down from a 9.1% reading for June.

“It’s hard to separate the idea of a recession from the idea of fixing inflation,” said Mark Heppenstall, chief investment officer of Penn Mutual Asset Management, which manages $31 billion from Horsham, Pa. “The thinking is that in a recession, inflation should roll over, even though it’s unlikely to reach the Fed’s target anytime soon.”

Last July, Heppenstall was one of the few people to openly say that the bond market might be underestimating the chance of a prolonged spell of higher inflation, a spell which came to fruition. Now, he said, the Fed is unlikely to push its main policy rate target above 4%, from a current level between 1.5% to 1.75%, without “driving the economy down to a point where the Fed overdoes it.”

“The pandemic is creating superfast moving cycles, mini-cycles, and the idea is that maybe the inflation cycle is increasingly severe, but short-lived,” Heppenstall said via phone. “So one can argue that inflation is more likely to be persistent, but the market is saying the Fed won’t have to hike as much as previously feared given recent bad data.”

Much is riding on the view that inflation should ultimately subside in an economic downturn and return to a more normal-looking pre-COVID environment. But the past year has also proven just how wrong so many people can be, and how it can take just one shock — like Russia’s war in Ukraine — to upend common assumptions. If investors and traders prove to be wrong about the path of inflation again, the result will inevitably be further volatility in the second half of the year similar to the brutal first half for stocks and government bonds.

A raft of weak data is cementing the idea that the U.S. is heading into a slowdown, sending all three major stock indexes DJIA, -0.43% SPX, -0.93% COMP, -1.87% lower in the afternoon and investors flocking to the safety of government bonds. Data released on Friday showed signs of a worrying deterioration in the economy, as reflected in preliminary data from S&P Global’s purchasing managers’ indexes.

And on Thursday, weekly jobless claims rose to the highest level since November, the Philadelphia Fed manufacturing index unexpectedly fell deeper into negative territory, and the Conference Board said its leading economic index shows that a U.S. recession around the end of the year and early next is now likely.

In a note released Friday, Deutsche Bank said that “the market is increasingly trading a ‘peak inflation’ world view.” The terminal fed funds rate, or level at which the Federal Reserve is seen as ending its current rate-hike cycle, has drifted below 3.5%, down from 4% to 4.25% five weeks ago, said macro strategist Alan Ruskin.

Of the five scenarios he envisions could unfold, the one that the market is mostly “flirting” with right now involves a “soft landing,” or no recession, and a terminal rate of 3% to 3.25%. Meanwhile, the market and the Fed are prone to “push back” against a second scenario in which inflation remains mildly stubborn, the U.S. experiences a shallow recession, and the terminal rate goes to between 4% and 4.25%. A third “outlier” scenario is one that entails a “rate-induced hard landing,” or deep recession, and a terminal rate above 5.5%.

Rather than viewing each scenario as “discrete,” the three possible outcomes “might represent stages in a more extended tightening cycle, and blend together in a staggered hiking cycle that extends well beyond the current priced peak in the funds rate in January,” Ruskin wrote.

According to Keith Lerner, the Atlanta-based co-chief investment officer and chief market strategist for Truist Advisory Services, “the market is pricing in a high probability of a recession that might be mild, and that will help inflation somewhat.”

“We’re already seeing signs of some deflation signals in commodity prices and in expectations,” Lerner said in a phone interview Friday.

There’s one major factor that may still be missing from the market’s current overall thinking, however, and that is inflation’s historical pattern. In the 1960s and 1970s, “many underestimated the persistence of inflation over time,” said John Silvia, founder and chief executive of Dynamic Economic Strategy in Captiva Island, Florida.

Now, “financial markets are again underestimating the persistence of inflation that runs significantly above the Fed’s 2% target over a longer period of time,” Silvia, the former chief economist at Wells Fargo Securities, said via phone. “Therefore, markets are gambling on how serious the Fed is going to be in pursuing its inflation target, at the expense of its legacy. If we are talking about getting inflation back down to 2% or 2.5%, that won’t be solved by anything like a short, simple recession.”

This article was originally published by Marketwatch.com. Read the original article here.

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