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Market Extra: Hottest U.S. inflation rate in almost 40 years brings sigh of relief in some corners of financial markets

The hottest U.S. consumer inflation reading in almost 40 years is bringing a surprising sigh of relief in certain corners of the financial markets, where some were expecting a headline year-over-year number closer to 7%.

The relief was evident in investors’ appetite for U.S. Treasuries Friday morning after the government’s consumer price index report, which showed the headline year-on-year reading at 6.8% for November. While undoubtedly high, the reading dodged the 7% level that a few saw as a risk, raising hope that inflation may be in the process of topping out.

Read: Traders see next U.S. CPI reading close to 7% as volatile markets try to shake off omicron and Federal Reserve’s hawkish pivot

While the CPI print was high, “some folks on Wall Street were expecting an even higher number” and the core CPI number, which excludes volatile items, “was in line with expectations,” said Tim Holland, chief investment officer of Orion Advisor Solutions.

“The two points above have many thinking that we are close to, if not at, peak inflation,” Holland wrote in an e-mail to MarketWatch. “That strikes us as a reasonable view, which would point us towards lower inflation going forward, which would support / justify little to no movement in yields.”

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Fixed income tends to be the asset class that gets hit hardest by rising inflation, which erodes the fixed value of bonds. Ordinarily, investors would be selling off Treasuries in response to a higher inflation print, which would lead to higher yields. Instead, ongoing demand for U.S. government debt, whether domestically or from abroad, pushed bond prices higher and yields lower Friday, as investors turn their attention to next Wednesday’s policy update from the Federal Reserve.

On Friday, yields fell across the curve, with the exception of 1-month and 2-month bill rates. The 10-year yield
TMUBMUSD10Y,
1.456%

slipped to around 1.45% and the 30-year
TMUBMUSD30Y,
1.854%

dropped to 1.84%, remaining near historically low levels.

Surprisingly, the 2-year yield, which reflects expectations for the near-term path of Fed policy, fell by the most, to around 0.64% which is still not far from the highest levels of the year. The move is counterintuitive because investors are expecting the Fed to proceed with a faster pace of tapering bond purchases, in order to have greater flexibility to hike interest rates sooner next year and combat inflation.

Meanwhile, equity investors brushed off the inflation print at first before all three U.S. stock benchmark indexes started giving up their earlier gains.

Gennadiy Goldberg, a senior US rates strategist for TD Securities, says the market pays less attention to the headline year-on-year figure than it does to the monthly numbers. “Yields are declining because month-over-month inflation didn’t come in as high as expected, and a lot of Fed tightening has already been priced in — with almost three rate hikes expected for 2022,” Goldberg said via phone.

“If you look at the long end and the pricing for rates in overnight-indexed swaps, the long-run terminal rate is just 1.5%,” below the 2.5% seen by Fed officials in September, he said. “That’s an indication that the market could be penciling in some policy error.”

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