As we mentioned last night, the Federal Reserve hiked by 75 basis points for the first time in 25 years. That initially led to a rally in risky assets and pushed Treasury yields lower. However, on Thursday morning, less than 24 hours after the Fed meeting, US stock futures are pointing to a sharply lower open for the S&P 500 and US Treasury yields are rising (prices falling), with the 10-year yield currently up 16 basis points so far today. While we had expected the risk rally to be short lived, we didn’t think it would turnaround so quickly. So, why is this happening?

Below we show you the most important chart out there right now, and we explain why it is the one chart to watch in the coming weeks and why it could foretell future Fed policy better than other market indicators.

Inflation expectations

As you can see below, the 5-year 5-year forward inflation expectation rate, as measured by the St Louis Fed, has turned higher and is inching up, it was 2.4% on Wednesday and we expect this to be higher post the Fed meeting as we move to the end of the week.

If this continues to move higher then it suggests two things:

1, That the market will push the Fed into future 75bp rate hikes in the coming months, which will push up the Fed’s neutral interest rate from its current rate of 3.8% at the end of 2023. Interestingly, ahead of Thursday’s meeting, the market had expected the Fed’s neutral rate to reach 4% by March 2023, thus it was looking for a more aggressive stance from the Fed than what the Fed’s own Dot Plot is predicting in the coming months. The Dot Plot suggests that the Fed will take a cautious stance towards hiking rates above the neutral rate. This is one reason why risky assets initially rallied on the back of Wednesday night’s Fed decision. However, the market thinks that the neutral rate should be higher, and we think that it will continue to push the Fed to embark on an even more aggressive monetary policy path in the short term.

2, If long-term inflation expectations continue to move higher then this could lead to upward pressure on wages, and a wage/ price inflation spiral. If that happens then inflation could be stickier for longer and it could even rise higher from here. This is a scenario that the Fed will want to avoid at all costs, and it could lead them to hike rates by more than they expected on Wednesday.

Considering the Fed’s inflation expectations have been wildly inaccurate in recent months and years, we could see an even more hawkish move from the Fed in the future. At this stage, we will not rule out a 100bp rate hike from the Fed in future, especially if long term inflation rates continue to move higher. No wonder risky assets are suffering once more.

Explaining the post Fed turnaround in risk sentiment