Friday's Market Minute: Inflation Meets A Complacent Market

The day after the Fed’s hawkish surprise, investors are trying to price in the end of monetary stimulus. Despite Wednesday’s pivot, the Fed is still at risk of either moving too fast or too slow on reining in easy monetary conditions. On Wednesday, the FOMC said that most officials expected a rate increase in 2023, up from a previous projection of 2024.

In three months, the Fed has bumped their 2021 inflation forecast from 2.4% to 3.4%. While the argument for transitory inflation is strong, the Fed’s reliance on actual data and not forecasts is raising the risk that they will move too slowly. The latest update to their forecasts perhaps demonstrates the complexity behind determining where inflation is going, and that has some traders nervous. The prospect of cheap money coming to an end hit U.S. equities and bonds in a mixed capacity. Technology stocks have made a comeback, and longer-term Treasury yields are lower, unable to break the downtrend that began in March. Materials, commodities, and industrials sold off and dragged down some of the Dow’s key components yesterday. This could add evidence to the idea that the rotation out of growth and into value has run its course and is starting to unwind.

Expectations of future inflation have steadily increased over the past year and are now above the pre-pandemic level. It is not surprising that inflation is higher in 2021 than it has been over the past two to three years, as it almost mechanically follows the pent-up desire of many households to spend because of the pandemic. Backlogs of orders should support further production growth in the next few months, adding to signs of impressive economic expansion over the summer.

However, growth expectations further ahead have moderated as expressed through lower treasury yields post-FOMC meeting. This suggests that the growth rate is peaking due to rising prices hitting demand and the multiplier effect of stimulus wearing off. As we near the end of the quarter, equity investors have exhibited complacency about inflation, which has suddenly risen over several months. Consumer purchasing power and altogether consumer confidence could erode just as fast as it ascended beginning in late 2020. Inflation risks could also erode companies’ upcoming earnings if they are unable to pass higher input costs on to their customers. If companies highlight such problems in their upcoming second-quarter earnings calls, the overall positive mood in the equity markets might face some challenging headwinds in the back end of the summer months.

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