Just When You Thought It was Safe to Go Back in The Water…

Stocks are under pressure, after a hotter-than-expected inflation report pushed the benchmark 10-year U.S. Treasury yield past 4.3%. Cue the “Jaws” theme.

The U.S. consumer price index (CPI) for January, released Tuesday, showed that inflation still has a bite. Year-over-year, headline inflation stood at 3.1%, slightly lower than the previous month’s 3.4% but surpassing forecasts of 2.9%.

Core inflation, which excludes volatile food and energy prices, rose by 3.9%, consistent with the previous month but surpassing predictions of 3.7%.

In the wake of the CPI report, stocks sold off on Tuesday. The CBOE Volatility Index (VIX), a barometer of market stress and fear, surged to hover at around 15.

In another bearish signal, the benchmark 10-year U.S. Treasury yield (TNX) spiked past 4.31%, nearing its peak for the year (see chart).

Equity valuations have gotten stretched this year, with the main indices breaking records. “Big Tech” stocks, in particular, have been frothy and vulnerable to a pullback.

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I’m still bullish over the stock market’s long-term prospects this year. Disinflationary forces remain in play and interest rates will eventually ease in the coming months. After the Dow Jones Industrial Average and S&P 500 hit record closing highs in recent days, a breather was inevitable.

Wednesday’s rebound…

In fact, dips such as we experienced Tuesday can be interpreted as buying opportunities.

The main U.S. stock market indices bounced back Wednesday and closed higher as follows:

  • DJIA: +0.40%
  • S&P 500: +0.96%
  • NASDAQ: +1.30%
  • Russell 2000: +2.44%

The VIX fell 9% to about 14. The TNX retreated by 1.14%, but it still hovers at the dangerous level of 4.26%. Until the TNX falls back below the 4.0% inflection point, investors will be on edge…and rightfully so.

All eyes are on the producer price index (PPI) report scheduled for release Friday.

The PPI measures prices at the wholesale level. If this inflationary measure also comes in hotter than expected, stocks are likely to sell off again.

Inflation isn’t vanquished just yet…

The January CPI reading was a big disappointment. While certain sectors such as gas prices, energy services, and used car pricing witnessed moderation in inflation rates, this was counterbalanced by increases in categories like dining out, housing costs, and transportation services, including vehicle insurance.

Notably, the significant driver behind the inflation surprise was the surge in housing and rent costs. However, real-time data indicates a softening trend in rent prices, suggesting a potential easing in this component of inflation over time, albeit not in a linear fashion.

This unexpected inflationary surge coincides with a period where the S&P 500 has seen substantial gains of nearly 22% since its lows in October 2023.

Despite the discouraging data, which highlights potential hurdles in achieving the target inflation rate of 2.0%, the prevailing narrative of improving inflation trends, a potential shift in Federal Reserve policy towards rate cuts, and an economy poised for a slowdown without entering a recession, remains intact for the foreseeable future.

Following the release of the inflation data, market expectations for Federal Reserve rate cuts have undergone a significant adjustment.

According to the CME Group’s FedWatch tool, the probability of a rate cut at the Fed’s May 1 meeting dropped to just 34%, compared to recent readings of 52%. Additionally, markets are now pricing in approximately four rate cuts for 2024, down from the initial five or six anticipated at the beginning of the year.

In my assessment, market sentiment now aligns more closely with what’s the most probable outcome: three to four rate cuts in 2024, likely commencing around June.

With the U.S. economy demonstrating resilience amid higher interest rates, the U.S. central bank can afford to exercise patience in implementing rate cuts this year to ensure inflation converges towards the target of 2.0%.

Given that core CPI inflation remains elevated at 3.9%, the Fed will likely await further signs of progress before signaling the start of a rate-cutting trajectory.

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John Persinos is the editorial director of Investing Daily.

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