It’s been a head-scratching week in various asset classes — one that left investors and traders coming away with different conclusions about what lies ahead after data releases showed U.S. inflation easing more than forecasters expected.
Some are describing the stock market as “euphoric” about the possibility that the worst of inflation is behind: Major indexes continued to rebound strongly from their mid-June lows. Oil futures posted weekly gains as fears of a sharp global slowdown eased in parts of the financial market, but ended lower on the day. Meanwhile, the bond market has been flashing warnings of a possible economic downturn and more than half of the respondents in a BofA Securities FX and rates sentiment survey are concluding inflation will still require persistently tight policy, or more rate hikes.
This time of the year is filled with summer vacations and is typically accompanied by a period of trading inactivity, which traditionally translates into what BMO Capital Markets strategists call “listless price action and limited volumes.” But this cycle is anything but typical, they said.
“It has been a strange week for financial markets, filled with conflicting signals,” Marios Hadjikyriacos, a senior investment analyst at Cyprus-based multi-asset brokerage firm XM, wrote in a note.
Rather than definitively settle the debate on the path of inflation, Wednesday’s consumer-price index report, which showed the annual headline rate retreating to 8.5% in July, and Thursday’s producer-price data, which revealed the first negative monthly print since April 2020, ushered in more dialogue from policy makers on the continued need for higher interest rates.
On Friday, Richmond Fed President Tom Barkin said in a CNBC interview that while the inflation data was “welcome,” the Fed should still be raising its benchmark interest rate target until data show continuous progress. His remarks came as the Cboe Volatility Index, otherwise known as the VIX VIX, or the stock market’s “fear gauge,” tumbled back below 20 for the first time since April.
Read: Is the stock market’s favorite ‘fear gauge’ signaling more pain ahead for investors?
Complicating the inflation outlook for some is that an argument can be made that not all price pressures are easing, despite growing signs of a turning point in inflation. According to Simon MacAdam, a senior global economist for Capital Economics, “red-hot” labor markets and elevated inflation expectations mean that “underlying sources of inflation remain intact.”
There are “plenty of skeptics around who will punch that August is an euphoric overshoot” in equities, “giving the market the excuse to trade bad news is good and good news is also good,” said Ben Emons, managing director of global macro strategy at Medley Global Advisors in New York. “For those who think the market is a little too euphoric about peak inflation, the collapse in volatility presents attractive levels to buy puts.”
Gold — which has generally underperformed as an inflation hedge this year — swept to a fourth week in a row of price gains, the longest stretch since December, despite a post-CPI retreat on Thursday and earlier on Friday.
In other post-CPI moves this week, the ICE U.S. Dollar Index DXY fell off on Wednesday and Thursday even as long-term Treasury yields soared — when ordinarily they should be moving in tandem. The divergent paths of the greenback and U.S. bond rates were significant enough to be singled out by XM’s Hadjikyriacos.
The cool down in both consumer and producer prices “sparked hopes that the worst days of inflation were behind us and the Fed wouldn’t need to be quite so aggressive in raising rates, dealing a blow to the US dollar,” said the investment analyst. “But the bond market refuses to endorse this narrative,” Hadjikyriacos said, adding that long-dated yields are poised to end up for the week anyway on the view that a “trigger-shy Fed today could translate into higher inflation down the road.”
In other words, he said, “forex [foreign-exchange] traders focus on the near-term prospect of the Fed easing off the brakes whereas bond traders take a more holistic view that the inflation battle is not nearly over.”
On Friday, stocks finished sharply higher as the S&P 500 SPX booked its fourth straight weekly gain and Dow industrials jumped 424 points. Treasury yields were mixed, keeping the spread between the 2- BX:TMUBMUSD02Y and 10-year rates BX:TMUBMUSD10Y deeply inverted at minus 41 basis points in a worrisome sign of the outlook. The ICE U.S. Dollar Index was up by 0.5%.