The subtle shift in financial markets indicates that the US economy may be able to handle higher rates

There is a subtle shift taking place in some corners of the financial market towards the idea that the US economy may be strong enough to handle higher interest rates which can help reduce inflation.

Signs of that sentiment shift were evident in Treasuries, where yields remained substantially higher across the board on Wednesday, led by 3- to 7-year rates. Meanwhile, fed funds traders have swung back and forth between expectations of a 75bp and 50bp rate hike in September, while inflation-adjusted 5, 10, and 30-year yields are all went higher in morning trading.

Sentiment has fluctuated over the past week between optimism that inflation is fading – as expressed by US equity indices remaining well outside mid-June lows – and pessimism that Federal Reserve hikes to fight inflation they will produce an economic recession, as reflected in a deeply inverted treasury curve. Although the July Consumer Price Index report indicated that the drivers of inflation “show some relief,” a still strong US economy is now keeping the risk of a couple more rate hikes alive. basis points from the Fed, said Ed Moya, senior market analyst for the Americas at OANDA Corp.

The better-than-expected CPI data improvement in July gave many hope that inflation could peak, while reinforcing the gloomier view in the foreign exchange and rate markets that persistently tightening policy is needed by the US. Fed to reduce price gains. The subtle shift in thinking that is taking place now is that the economy may be stronger than previously thought, as reflected in Walmart Inc.’s better-than-expected fiscal second quarter profit and revenue wmt,
+ 0.32%
Also, while retail sales were flat for July, the data contained enough good news to satisfy optimists.

“The outlook for the economy has changed,” Moya said over the phone. “We had a slowdown in June and July, but that’s not the case. Walmart and retail sales are supporting optimistic outlook this week. “

To be sure, the financial markets have continued to absorb a stream of data since August 19th. 10 CPI keeping inflation concerns alive, including Wednesday’s report that UK annual consumer prices rose 10.1% in July. Meanwhile, oil futures rose for the first time in four sessions on Wednesday. And the results of an online survey of 70 business executives, entrepreneurs and private equity investors from July 18 to August 18. 5 showed that 50% were “very worried” about the impact of inflation in the near future, according to Stifel, Nicolaus & Co.

“The theme of high inflation continues to plague developed markets and is likely to do so for the rest of the year,” said BMO Capital Markets strategist Ian Lyngen.

However, the latest sentiment shift reflects a slight adjustment from the second quarter, when fears of an impending US recession dominated. Concerns about a decline have not entirely faded, in fact, the Treasury curve is still issuing a warning, via a deeply negative spread between 2 and 10 year rates. But behind that worrying signal is also the fact that traders have mostly considered the possibility of a Fed rate cut next year.

“Surprisingly, there have been very few warnings or comments that expectations for Fed rate cuts for 2023 have almost recently disappeared,” said John Vail, chief global strategist at Nikko Asset Management. Indeed, while federal funds futures once predicted cuts in the first half, an increase is now partially discounted, while 2023 only predicts a cut of less than 25bps. This is likely due to the Fed’s hawkish speeches rather than any change in macroeconomic fundamentals. “

The recent equity market rally and the easing in financial conditions that followed are also likely playing a role in expectations that the Fed will not need to cut rates, Vail wrote in an email. “This corroborates our view that the Fed should be more aggressive than consensus due to sticky core inflation and will likely be a barrier to risk markets once properly noticed,” the strategist said.

Since Wednesday, all three major DJIA stock indices,
-0.02%

spx,
-0.16%

COMP,
-0.52%
they were late before the minutes of the Fed meeting for July were released. Meanwhile, a sell off of government bonds pushed the 2-year TMUBMUSD02Y yield,
3.286%
more than 3.3% and 10-year yield TMUBMUSD10Y,
2.882%
up to 2.9%.

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