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Recent reports indicating persistent inflation have shaken investor confidence in the imminent start of a series of interest-rate cuts on Wall Street. Investors are now cautiously optimistic, hoping that the fourth attempt will yield better results.
There is a renewed sense of optimism regarding a soft landing for the U.S. economy, which has been reflected in trading activities leading up to the release of the consumer-price index. Federal Reserve Chair Jerome Powell has kept the possibility of rate cuts alive following the central bank's latest policy meeting. Subsequent data has shown a slight easing in pressure from job and wage growth, helping to push stocks back towards record levels.
Persistent inflation has been a major concern for investors in recent months. Traders began 2024 expecting as many as six rate cuts, only to rapidly scale back those expectations as the CPI consistently exceeded expectations. This led to a stock market shake-up in April and drove bond yields, which rise when prices fall, to their highest levels since November.
Many investors found some relief in the April employment report, as a cooler labor market should eventually lead to more moderate price increases. Now, they await actual inflation data to confirm this trend.
"The CPI report could significantly advance the narrative of impending rate cuts this year," said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities.
Stocks and bonds are closely linked. Yields on Treasurys are heavily influenced by investors' expectations for short-term rates set by the Fed. Stock prices, in turn, are guided in part by investors' comparison of the risk-free return they can get from holding Treasurys to maturity. The Dow Jones Industrial Average has already climbed 4.5% this month, bringing it to less than 1% below its record reached in late March. A rally in bond prices has driven the yield on the 10-year U.S. Treasury note down to 4.503% from 4.7% in late April.
Many investors believe that if inflation moderates, the upside for bonds is greater than for stocks. While stocks are already near records, the yield on the 10-year note remains well above the sub-4% level where it started the year.
Bond returns have been disappointing over the past couple of years because interest rates climbed higher than expected and then remained at those levels longer than anticipated. Nonetheless, investors have been eager to buy bonds at the slightest hint of easing inflation, keen to lock in 4%-5% yields before the Fed starts cutting.
Ed Perks, chief investment officer of Franklin Income Investors, suggested that yields could drop by as much as 0.2 to 0.25 percentage point on shorter-term Treasurys and 0.1 to 0.2 percentage point on longer-term Treasurys if data shows inflation moderating. He also noted, "It’s a bit more of a challenge to see a significant upward move in equities" given current stock valuations. For the same reason, he added, stocks probably have more room to drop if inflation is once again higher than anticipated.
Inflation has already fallen sharply from a peak in 2022. The question now is whether it can return all the way to the Fed’s 2% target, as measured by the central bank’s preferred personal-consumption expenditures price index.
Excluding volatile food and energy categories, 12-month core PCE inflation dropped to 2.9% at the end of last year from 4.9% at the start. But it has since stalled, standing at 2.8% at its latest reading in March.
Adding to the pressure on Wednesday’s CPI report is a quirk of the calendar, which means the report will offer investors a better-than-usual view of what PCE inflation will look like later in the month.
Typically, the CPI data is released before the producer-price index report, leaving investors with some initial uncertainty about the Fed’s preferred gauge. But this month, PPI data will come first, on Tuesday, allowing investors to calculate PCE rapidly Wednesday morning.
Many economists remain optimistic that inflation will resume its downward trajectory. Inflation in goods has already slowed to about where the Fed would like. Official measures of housing inflation have remained stubbornly high, but economists still expect them to moderate to come more in line with private-sector gauges of new rent increases.
Inflation in other types of services tends to move slowly both on the way up and on the way down. But the recent report showing cooling in the labor market was a positive sign, since the cost of labor tends to be a major driver of price changes in this category.
In addition, economists note that inflation in some types of services tends to lag behind inflation in related goods. For that reason, many expect increases in the cost of insuring or repairing a car to ease in the coming months, given what has already happened with new- and used-car prices.
Still, few at this point are underestimating inflation’s capacity to surprise in any given month.
George Mateyo, chief investment officer at Key Private Bank, said it still makes sense to own unconventional assets—such as real estate, inflation-protected bonds, or international stocks—to hedge against another hot reading, given that a bad report would likely hurt U.S. stocks and bonds alike.