Inflation Shock Hands US Stocks Worst Day Of 2022

Risk assets weren’t enamored with another disconcerting US inflation report.

US equities crumbled after data for August showed core prices rose at double the expected monthly rate.

The figures, which included the hottest pace of monthly shelter inflation in three decades and another month of double-digit annual price growth for electricity and groceries, cemented an already rock-solid case for a 75bps rate hike from the Fed at this month’s policy meeting.

The data also raised the odds of a fourth straight super-sized hike in November, and prompted traders to price in some chance of a 100bps move from officials next week.

By the time the dust settled on Wall Street, US shares suffered their largest single-session decline of 2022 (figure above).

“Today’s gap down [puts] us in tricky territory ahead of quarterly options expiration, where we now see dealers back in ‘short gamma’ territory across the board in US equity index options, which means their hedging flows could act as an ‘accelerant’,” Nomura’s Charlie McElligott remarked.

The curve bear flattened aggressively, as two-year yields catapulted to new “since 2007” highs (figure below), while 30-year yields actually ended slightly lower on the day after a decent auction.

“Clearly, CPI throws out any talk of the Fed potentially surprising with a 50bps hike next week, but it isn’t calamitous enough to see a big push for 100bps,” ING’s James Knightley, who does expect price pressures to subside going forward, remarked. “The breadth and stickiness of inflation pressures has seen the market shift its expectations for the terminal rate up to 4-4.25% from the 3.75-4% range before the CPI release,” he noted.

Unfortunately, the hot read on core suggested virtually no “flow-through” (if you will) from lower energy prices to ostensibly unrelated categories. In fact, it may suggest just the opposite — that relief at the pump is increasing demand elsewhere, thereby exacerbating mismatches with supply.

BofA on Monday said lower gas prices last month prompted consumers to spend more in other categories, with the end result being a 5% YoY increase in August card spend. The bank sees “solid growth in real consumer spending,” but cautioned that “good news is not always good news.” They raised their terminal rate forecast to 4-4.25%, which looked prescient on the heels of August’s CPI data. A higher terminal rate “increases the risks of a harder landing next year,” BofA warned.

“It goes without saying that today’s data has upped the ante for terminal projections, and we’ll be eagerly awaiting how the Fed chooses to signal the most likely path of policy rates via the dot plot,” BMO’s Ian Lyngen and Ben Jeffery wrote. “Prior to the upside surprise on core, we were anticipating the SEP would indicate a rate peak in the 4-4.25% zone [but] it’s now prudent to add another quarter point and expect 4.25%-4.50% is the FOMC’s updated objective,” they went on to say. “As is all too often the case, the Fed is playing catchup with market pricing in this regard.”

The hot inflation figures despite falling energy prices may mean wages are becoming a more important driver of price growth. That’s a euphemistic way of saying the wage-spiral is real, even if wage growth by and large isn’t. (See what I did there?)

The inflation numbers raise the stakes for retail sales and University of Michigan inflation expectations, both due later this week. BofA’s card spend data certainly seems to suggest there’s upside risk to the former, although the drop in gas prices almost surely means the inflation outlook from the Michigan poll will be benign.

For markets laboring beneath the inexorably stronger dollar, Tuesday was a veritable gunshot to the knees. Gauges of broad dollar strength spiked hard following the numbers (figure below).

The euro erased Monday’s big gains, falling back below parity. The beleaguered yen tumbled 1.2%. And sterling fell 1.6%. The currency crisis rolls on.

Fair warning: It feels like we’re one more hawkish escalation away from a “last straw” moment. Valuations in the US haven’t caught all the way back down to levels implied by the rapid run up in real yields. At the same time, the higher US yields go, the worse for the yen. And the more aggressive the Fed is, the harder it’ll be for Christine Lagarde to match Jerome Powell over this year’s remaining policy meetings, especially in the context of what almost everyone now acknowledges is an oncoming recession in Europe.

Coming quickly back to the US curve, TD’s Priya Misra sees a deeper inversion. “The market should price in the impact of rate hikes and QT on the economy — these come with long and variable lags, but over time we expect growth to slow,” she said, initiating a 2s10s flattener. Risk assets, she suggested, will struggle as the odds of the Fed “overdoing” it increase. Tighter financial conditions and the prospect of a downshifting economy may mean “some investors look at long-end Treasurys as a hedge.”