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Market paradox – the higher rates are today, the lower inflation will be tomorrow 

Market paradox – the higher rates are today, the lower inflation will be tomorrow 

created Daniel Kostecki15 February 2023

Yesterday's behavior of the financial markets on the reading of inflation data could have caused a lot of emotions, and the charts resembled a speeding rollercoaster - once up, once down.

On the one hand, market consensus was partly collected before the publication of the data, taking into account the old weights BLS, hence the reading could be above the official estimates, and on the other hand, the market consensus could be higher due to the knowledge of BLS overestimating the weights. A mixed reaction in the first moments was observed on the US dollar or stock indices, but investors in the bond market and futures on the federal funds rate had no doubts. There, the reaction seemed to be unequivocal, i.e. a weaker fall in inflation, whatever the reasons, means higher yields - especially at the short end - and more chances for further tightening by the Fed.

What is the market paradox?

We used to think that high Fed rates were bad for the stock market, bad for the economy, and bad for the job market. Plus high rates Fed, a high-interest dollar, is trouble for developing economies with USD-denominated debt and a higher risk-free rate (why buy risky stocks when you can have 5% risk-free). This side of the market is absolutely right, but the other side, the one that wants to take the risk, can also find something for themselves.

We are talking about a situation where, thanks to further interest rate increases now and keeping them high in 2023 (the market has already overestimated its bias and assumes that the upper band of the federal funds rate will be at 5,5% for the vast majority of this year), the Fed will be sure that inflation will not perpetuate and take root in the American economy. What does it mean? Higher Fed rates today may mean greater certainty of lower inflation tomorrow. As a result, market expectations for inflation for the year in the US are already close to the Fed's target, as in the region of 2,5 percent. This, in turn, contributes to the loosening of financial conditions in the US despite the tightening of policy by the Fed at present. The market looks further, a year ahead, and sees that the chances of inflation falling to the target are greater, which may make investors happy.

Inflation in the target in a year or 1,5 years, in turn, is a chance for interest rates to drop to around 3,75 percent. in the first half of 2024. If we look at the forward P/E ratios, which also try to estimate the future 12 months ahead, then in relation to the estimated rate at 3,75%. they seem quite attractive already. Hence the market paradox of higher rates today and the certainty of lower inflation tomorrow.

Threats to such a scenario

Threats include, above all, the lack of inflation decline at the rate currently expected and the need to increase wages, e.g. over 6 percent. This could demolish the current bull narrative.

Plus, derailing the economy with high rates, but here the Fed is taking into account that GDP could even fall and the unemployment rate could go up to 4,5 percent. from 3,4 percent Currently.

The biggest threat, however, would be a drop in demand and uncorked deliveries. So high interest rates and QT pull money from the market, and there are more and more goods, because supply chains work properly, and companies still see a strong consumer and produce more. More goods, less dollars? This is a deflationary scenario… but we will get to that as the situation develops in the coming quarters.

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About the Author
Daniel Kostecki
Chief Analyst of CMC Markets Polska. Privately on the capital market since 2007, and on the Forex market since 2010.