A Wide Range Of Potential Outcomes
Cutting Rates Now Seems Egregious
Even though the CPI and core CPI inflation readings came in above expectations (with the core inflation annualized rate still at 3.9%), the markets paid more attention to the PPI numbers, which showed the third consecutive monthly decline and an annualized rate of 1%. That was enough to adjust the market’s expectation to 7 quarter point rate cuts by the end of 2024 and give 2023’s winners, mega-cap growth & tech, another jolt. There comes a point where investor expectations become so disconnected from market fundamentals that it almost begs for a correction to pull things back in line. We may be at that point with inflation and monetary policy rates. Regardless of any reading on current conditions, the basic idea that the Fed would cut rates 7 times when the annualized core inflation rate is still running near 4% seems egregious on the surface.
That creates a very wide range of potential outcomes for the bond market. If inflation can’t make meaningful progress towards the Fed’s 2% target, the central bank is likely going to come nowhere near the 7 rate cuts that the market is pricing in right now. In order to close that gap, rates would likely need to move much higher to reflect that new reality. On the other hand, we’re seeing plenty of evidence of macro conditions deteriorating quickly in both China and Europe (and potentially the U.S. if you view the miserable ISM services employment report as a sign that the labor market could be ready to crack). If that helps trigger a flight to quality trade as recessionary conditions build, then you’ve got the bullish case for bonds. It’s entirely possible that the 10-year Treasury yield could be anywhere between 2% and 6% by the end of 2024 and that will make risk management techniques all the more important in the near future.
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