Unanswered Inflation Questions Fuel Uncertainty

Look beyond the headlines to discover the driving forces behind market trends and consider how they impact a credit union’s investment portfolio.

 
 

Top-Level Takeaways

  • The biggest unanswered question for financial markets is how the U.S. economy will respond to high inflation and tightening financial conditions.
  • Some Fed leaders have expressed an openness to pausing or slowing down the pace of rate hikes, but chair Powell and others have reiterated a commitment to ensuring inflation is clearly moving back toward the 2% target.
  • Despite some flashes of stability this year, heightened volatility in the market is likely here for to stay – at least until the Fed sees evidence of inflation reversing course.

The primary question still being pondered by financial markets is how the U.S. economy will respond to high inflation and tighter financial conditions via the efforts of the Federal Reserve and other major central banks. When the major central banks go full reverse on extraordinarily accommodative policies at the same time, financial markets are not expected to respond well, and for much of the second quarter they have not. Through June 17, the S&P 500 was down 18.5% in the second quarter, and the 2-year Treasury yield reached a high of 3.43% on June 14, up 109 basis points from the end of the first quarter.

Volatility in June has been particularly severe, thanks in large part to two separate economic reports released on June 10. First, the May CPI report was alarming for market participants and central bankers alike, revealing higher-than-expected readings for both headline and core inflation. Later that morning, the University of Michigan consumer sentiment survey set a new record low, which is remarkable given that the survey was first initiated in January 1978. In other words, even with unemployment near record lows, consumer sentiment is lower today than it was during the financial crisis in 2008, in the aftermath of 9/11, the dot com crisis, and the 1987 stock market crash. This shows the power of inflation as it relates to consumers’ psyche, and the report also showed long-term consumer inflation expectations surging 30 bps to 3.3%.

The combination of these reports sparked a violent sell-off in the bond market, with the 2-year Treasury yield rising 54 bps in just two days as the market repriced for 75 basis-point rate hikes at both the June and July meetings. The Fed took the markets cue and raised the federal funds target range by 75 bps on June 15, and the updated summary of economic projections revealed a much more hawkish perspective from FOMC participants relative to the previous update in March. The median forecast now shows a 3.4% funds rate by year end and peaking at 3.8% in 2023, more closely aligning with what the bond market had already priced in.

There have been flashes of stability in financial markets in 2022, but they have been short lived. Looking ahead, heightened volatility will likely remain a prominent theme until there is evidence of inflation reversing course. There will likely be increased recession talk as consumers and businesses alike deal with the impact of inflation and tighter financial conditions, but Fed Chair Powell has made clear that only when clear and sustained signs of inflation return to the Fed’s long-run target will he and his colleagues slow or end the tightening efforts, even if it brings economic pain in the process.

This market commentary is provided by ALM First Financial Advisors, LLC, the investment advisor for Trust for Credit Unions. Visit trustcu.com to read about the latest economic data and overall market trends.

This article has been updated from its original version to reflect more current market data.