Inflation nation: trading a 50 bp hike from the Fed in March

The biggest news of the day was the US CPI report for January. Prices surged to 7.5% on an annual basis, a fresh 40-year high, and the core rate rose to 6%, higher than the 5.9% expected. The market had a knee-jerk reaction to this latest data: stocks sold off sharply, the dollar rose initially, although it gave back earlier losses, and Treasury yields jumped, along with sovereign bond yields in Europe. The question now is, with risk aversion on the rise, where are the safe harbours? And what do sharply rising Treasury yields mean for markets?

Historic move for yields 

US inflation has consistently surprised to the upside in recent months and this has caused the bond market to steal the limelight from stocks. Where Treasury yields go other global bond and equity markets follow. The magnitude of Thursday’s move in US Treasury yields is worth noting, the 10-year yield surged above 2% for the first time since 2019. 2% is a psychologically important level for traders, and due to the market’s fondness for round numbers, hitting this level caused a selloff in other risky assets. 2-year Treasury yields also surged, jumping 20 basis points to 1.59%. To put these moves into context, the last time the 1-day 2-year swap rate moved by 20 basis points was November 2008, and before that it was the peak of the financial crisis in November 2007. These are historic moves and are usually associated with major crises in global economies. While there are some risks out there, including the threat of Russia invading the Ukraine, overall economies are strong. Although analysts have downgraded their EPS estimates for S&P 500 companies for the first quarter of 2022 by 0.7%, this is a smaller decline than the 5-year average. Added to this, the outlook for inflation over the long-term is relatively subdued and has been in decline since November 2021. Breakeven rates, derived from inflation-protected Treasuries, show that inflation is expected to come in below 3% in both a 5 and 10-year horizon. Thus, what does this historic surge in US yields tell us? 

1, The market is testing the Fed’s aim to keep price stability under control. 

2, The sharp rise in Treasury yields is a significant pre-tightening of financial conditions before the Fed has actually raised interest rates. 

3, There is growing pressure on the Fed to front-load rate hikes, especially since inflation pressures continued to broaden in January, with prices firming in the service sector, along with brisk demand for goods and continued supply chain issues in the US. 

Market pricing for an aggressive Fed 

The Fed is now under pressure to act, as it is accused of being behind the curve on inflation. While markets don’t like inflation, they also don’t like aggressive central banks. The market is currently pricing in 6 rate hikes for this year, with the CME Fedwatch tool now pricing in a near 90% chance of a 50-basis point hike to 0.50-0.75% after St Louis Fed President James Bullard said that he would endorse a 50bp hike next month in an interview on Thursday, the first Fed official to do so. There is now a 36% chance that US interest rates could rise to 2%-2.25% by the end of this year! We had spent so long reaping the rewards of pumped-up stock markets and zero interest rates that the market is now adjusting to a short, sharp shock from the Fed.  The bond market also has to cope with the end of Fed asset purchases from next month, which means that there is more supply of Treasuries in the system, this is weighing on prices and pushing yields higher. With the Fed no longer a buyer of assets, yields can and most likely will, continue to move higher. 

The Fed risks a misstep 

Of course, the faster the pace of rate increases, the more likely the chance of an economic contraction and a rise in financial market volatility (which we have already seen). Most analysts and Fed officials see the neutral Fed funds rate at between 2-3%, and the market is pricing in the year-end Fed funds rate to come in between these levels. The risk is that the Fed extends its tightening cycle to bring the Fed funds rate above its neutral rate in a deliberate attempt to weaken growth and dampen inflation. This would be a gutsy move from the Fed and could trigger a much larger wave of volatility than we have currently witnessed. However, we only see this happening if inflation remains stubbornly high. We would note that although annual price increases rose to a 40-year high, the monthly rate of increase was 0.6%, down from a high of 0.9% in November. This could be a sign that inflation pressures have peaked, however, it could take some time for this to lower the annual rate of CPI. 

How to trade stocks when the Fed is poised to raise rates by 50 bp 

In this environment, you want to buy stocks that can perform well in an inflationary environment and continue to generate profits. This is why we prefer: 1, the FTSE 100 as an index, due to the large number of energy and financial companies that benefit from high inflation and rising interest rates, respectively. On an individual stocks’ basis, we like consumer staples including food companies for example the Andersons in the US, a diversified agriculture company, which has already experienced three strong consecutive quarters, and recently raised its quarterly dividend by more than 3%, which is another incentive for shareholders. In the UK we like Tesco. It is the largest grocer in the UK and has a $30bn market cap. Tesco has boosted its customer base during the pandemic, which leaves it in a good position to benefit from the 5% expected increase in supermarket prices this year. Its share price is at its highest level since 2014, however, a breach of the 300 level, a key level of resistance, could lead to more upward momentum. Its stock price rose more than 1.1% on Thursday, beating the UK index, and we expect further outperformance in the coming months. 

Cracks could appear in euro rally 

In the FX space, the dollar rose on a broad basis on Thursday after the release of the US CPI report, it is currently trading sideways in early Friday trading. EUR/USD is our FX pair to watch in the short term. Although EUR/USD had attempted to break through the $1.15 level before the CPI report, the highest level so far this year, it couldn’t break through this resistance zone. We think that euro upside could be limited in the short term, especially since we think that the even if the ECB does hike rates this year it will be nowhere near as aggressive as the Fed. Added to this, Italian 10-year bond yields are on the rise once again and rose by 12 basis points on Thursday. If the spread with German bunds continues to widen then there could be a sovereign debt risk premium added to the euro, which may limit the single currency’s upside potential in the short term.