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Market Extra: ‘Blowout’ U.S. inflation leads traders to largely price in a half-point March rate hike by the Fed

January’s hotter-than-expected 7.5% annual U.S. consumer price inflation report has fed-funds futures traders aggressively raising bets for a half percentage point interest rate increase by the Federal Reserve in March, which would be the first hike of that magnitude in more than 20 years.

The inflation report, which exceeded expectations, is raising concerns in some corners of financial markets that U.S. inflation has yet to hit its peak, and is challenging the prevailing notion among economists, traders and central bankers that price rises should start to head lower this year.

After the report was released Thursday, fed funds futures showed an almost 97% chance of a 50 basis point hike by the Fed next month, up from 24% a day ago, though the percentage kept rapidly shifting throughout the day, according to the CME FedWatch Tool.

The widely followed 10-year Treasury yield
TMUBMUSD10Y,
2.043%

broke above 2%, a mark last seen in 2019. Meanwhile fresh parts of the Treasury yield curve temporarily inverted and the bond market continued to transmit worrisome signs about the outlook through a flattening spread between short- and long-term rates. Meanwhile, some investors voiced concern that no immediate relief from the highest inflation rate in four decades is in sight.

Read: U.S. inflation rate climbs to 7.5% after another sharp increase in consumer prices

“This is a blowout number of epic proportions,” said Tim Magnusson, chief investment officer of Garda Capital Partners in Minneapolis. “There’s no weakness in this report at all and nobody had this kind of number in their projections. There’s no magic underneath it that suggests it is some type of quirk.”

“This is a number that, frankly, I think means the Fed should be hiking today,” he said via phone. “It’s their worst nightmare because there is no turn in sight in inflation, and nothing in this report suggests inflation is peaking. There’s now a more-probable-than-not chance of an 8% year-on-year reading next month.”

Concerns that the Fed might be missing the boat were raised around last November, with investors like Jay Hatfield of Infrastructure Capital Advisors, along with Stifel Chief Economist Lindsey Piegza, warning the Fed has “lost control” of inflation. At the time, Piegza said the Fed “should have moved a lot sooner to pull back on easy policy” earlier in 2021.

January’s report reflected broad-based gains, with a greater-than-expected monthly rise of 0.6% driven by big advances in rent, food and gasoline. A separate measure of consumer inflation that strips out volatile food and energy prices also rose 0.6% last month, the government said Thursday. The numbers followed a December annual headline reading, which came in at 7%.

“I would agree that we haven’t seen a peak to inflation just yet, but we’re probably getting closer,” said David Petrosinelli, a senior trader at InspereX in New York. “We have likely not seen the highs in inflation because higher wages tend to be sticky and more long-lasting. The larger question for the market is, ‘Does the market believe the Fed has the tools or the will to get this under control?’ Fed officials are in a very difficult position that they put themselves in.” 

In addition to pricing in a high chance of a half-point rate hike in March, which would be the first increase of that magnitude since May 2000, traders also boosted the likelihood that the fed-funds rate target could go to between 2% and 2.25%, from a current level of 0% to 0.25%, or even higher by December. A half-point rate hike in March would take the Fed’s main policy rate to between 0.5% and 0.75%.

On Thursday, Treasury yields were generally higher, with the spread between 7-year and 10-year rates briefly inverting. The spread between the 2-year
TMUBMUSD02Y,
1.607%

and 10-year rates
TMUBMUSD10Y,
2.043%
,
as well as the gap between 5-year
TMUBMUSD05Y,
1.970%

and 30-year rates
TMUBMUSD30Y,
2.325%
,
flattened as stocks sold off.

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