‘The case for runaway inflation is still not there, and instead it is asset prices that could run out of control,’ one trader says
Inflation traders expect annual headline CPI readings to remain above 3% for more than a year, starting from last June.
Now that March’s shockingly strong official jobs report is in hand, traders are expecting five more months of consumer-price index reports to show no further progress being made on the annual headline rate of U.S. inflation.
That rate is seen as likely to come in between 3.2% and 3.4%, starting with next Wednesday’s data for March and stretching through the August release of July’s CPI figures to extend the current nine-month streak of readings at or above 3%. Although the Federal Reserve prefers to focus on core readings from another gauge known as the personal-consumption-expenditures index, or PCE, the CPI numbers matter because of their influence on household expectations.
Despite the expected lack of progress in the Federal Reserve’s efforts to bring inflation sustainably back to its 2% target and the risk that inflation might go higher from here, “we still may not have any major asset-price depreciation,” said trader Gang Hu of New York hedge fund WinShore Capital Partners.
Hu has made a string of prescient calls in the past few years that make his views worth paying attention to. In February of 2023, he said inflation could easily take more than a year to decline by enough for the Fed to cut rates, which has turned out to be the case. In early July of the same year, Hu said markets were caught in a “self-defeating feedback loop” on inflation that made it likely the Fed would need to keep raising rates from levels of 5%-5.25%. Less than three weeks later, the Fed delivered another quarter-point increase, lifting its fed-funds rate target to 5.25%-5.5%, where it has remained since.
A year before that, in July 2022, the trader said inflation “is going to be stickier than most people imagine’’ — another take that has come to pass.
Now, Hu lays out a case for why the U.S. economy and financial markets appear to be shifting into a new stage of the current inflation era, one in which prices on all major assets can continue to climb even if the Fed can’t put a meaningful dent in price gains or start cutting interest rates. He boils it down to a combination of different factors — ranging from a greater division between winners versus losers among American businesses, $1.2 trillion in fiscal support that was signed into law by President Joe Biden in March, and a surge of immigration that’s helping the world’s largest economy to keep generating jobs.
Friday’s nonfarm-payrolls report showed the U.S. economy created 303,000 jobs in March, or 50% more than had been expected by economists. That capped off a week in which persistent inflation concerns stemming from a string of hotter-than-expected data translated into what’s known as a reflation trade — sending long-term Treasury yields to November highs, crude oil to its highest since October, and the Dow Jones Industrial Average to its worst day in more than a year on Thursday.
Thursday’s trading — which reflected fears about the prospect of higher-for-longer interest rates and tensions between Israel and Iran — gave way to a different kind of sentiment on Friday. On the final trading day of the week, investors, traders and analysts looked at March’s strong jobs report as good news, while sticking with the notion that inflation won’t likely be a major problem in the months ahead.
Even traders of derivatives-like instruments known as fixings, who are expecting 3%-plus CPI reports into summer, did not seem to be broadcasting any alarm over the trajectory of price gains yet.
“My thoughts are that the strength of the economy is a little surprising, and a lot of it is about fiscal spending,” Hu said via phone on Friday after the March jobs report. “This kind of support will certainly generate an inflation issue or at least an inflation risk. But the case for runaway inflation is still not there, and instead it is asset prices that could run out of control.”
A U.S. economy supported by fiscal policy “separates the winners from losers, and there will be winners and losers,” he said. Hu puts major technology companies in the first camp because they probably “don’t care” whether interest rates are “3%, 4% or 5%.” Meanwhile, smaller companies, such as startups, tend to land in the second camp, along with U.S. consumers, who are struggling with higher interest payments following the Fed’s string of rate hikes in 2022 and 2023, he said.
The addition of millions of immigrants to the labor force over the past few years is also helping the U.S. to create more jobs than might otherwise be the case and to keep growing without overheating, according to economists.
This all adds up to “what will probably mean more asset inflation than consumer inflation,” according to Hu.
“U.S. inflation doesn’t get to the 2% target and the Fed’s job becomes harder,” requiring policy makers to keep a lid on expectations by talking tough about the price-stability side of their dual mandate without necessarily following through on their median forecast for three quarter-point rate cuts this year, he said. “Because the economy will be so bifurcated between winners and losers, the Fed’s economic models might be less useful and there will be too much uncertainty over what the central bank should do” as long as inflation trends around 3%.
A week ago, the Dow Jones Industrial Average and S&P 500 ended at record highs to cap solid first-quarter performances.
April has gotten off to a shakier start, however. Though investors responded positively to the March jobs report by sending all three major stock indexes to higher finishes on Friday, the Dow Jones Industrial DJIA, S&P 500 and Nasdaq Composite all ended lower for the week. Meanwhile, Treasurys sold off, pushing 10- and 30-year yields to the highest closing levels since Nov. 27. Gold hit another all-time high and oil prices secured an almost 5% weekly gain.