Has the Fed Lost the Inflation Narrative?

Lawrence Gillum:

Last week's hotter than expected inflation reading has been the latest bug-a-boo for fixed income markets. Immediately after the March CPI report, yields jumped by 15 to 20 basis points to year-to-date highs and have continued to leak higher since the reading was the third hot print in a row, causing markets to be concerned about the prospects of sticky inflation. So the market is starting to price in a range of monetary policy outcomes, including the possibility of interest rate hikes. But in this edition of the LPL Street View, we explain why markets were right to price out rate cuts, but why we still think it's too early to start talking about more rate hikes.

Lawrence Gillum:

It seems like we just can't stop talking about the Federal Reserve. After an aggressive rate-hiking campaign that we think ended last year. Markets were expecting the Fed to start cutting interest rates as early as next month, but with an economy that continues to surprise to the upside, along with these inflationary pressures that are still too hot, it looks like it will still be a few months before we get those rate cuts. And the bond market may have finally taken the hint after numerous attempts to front-run rate cuts in 2024. The bond market is now taking a less aggressive stance on rate cuts than even the Fed has suggested. Even before the March CPI reports, the bond market had been discounting the potential of rate cuts in 2024. Now, coming into the year, bond markets had penciled in nearly seven rate cuts for 2024, which is the blue line and the number that we certainly disagreed with.

Lawrence Gillum:

Now, markets are hoping for two, which we think is more reasonable, but with the recent string of higher-than-expected prints, a major concern for fixed income markets and Fed officials alike is the prospect of inflation expectations becoming unanchored, which would likely mean the Fed has to raise interest rates again. Nominal U.S. Treasury yields can be broken out by an inflation expectation component along with an economic growth expectation. And year-to-date, the 10-year treasury yield is higher by about 0.75%. Of that increase, roughly 0.25% is due to an increase in inflation expectations, whereas the remainder of the increase is the market recalibrating its expectations on stronger economic growth so far, at least in terms of market pricing anyway, the sell-off in the treasury market has primarily been a function of a more resilient economy and not an increase in inflation expectations per se.

Lawrence Gillum:

This is important since the Fed is trying to tame inflation, and the longer these inflation pressures persist, the greater the chance businesses and consumers start to expect higher prices, which could influence behaviors and potentially further embed the prospects of sticky inflation. Now, inflation expectations have clearly increased, but not to the point where they would be considered unanchored. And if inflation expectations start to increase, we could start talking about scenarios that include additional rate hikes and not rate cuts anymore. But we're just not seeing that yet. At this point, the worst case scenario, in terms of Fed actions, is to keep rates at current levels into 2025 and not additional rate hikes. A sentiment echoed this week by Chairman Powell and other Fed officials. Markets were right in our view to price out the aggressive rate-cutting cycle that was priced in to start the year.

Lawrence Gillum:

But as long as progress is made on inflation, we think the Fed can still cut rates this year without reigniting inflation concerns. Our base case is still two or three cuts from the Fed this year, depending on the inflation data, of course, unless those inflation expectations become unanchored. Now, if there is a silver lining to the sell-off in the bond market and the potential for interest rates to stay higher for longer, it's that yields for high-quality fixed income remain elevated and provide attractive income opportunities. And while price appreciation may be limited until these inflationary pressures abate, which we think will happen, income levels remain attractive. Thanks for listening.