US Stagflation on the Horizon? Debt Market Concerns
Stagflation, the combination of high inflation and slowing economic growth, is once again raising investor concerns. Not long ago, the narrative that the U.S. economy was “exceptional” dominated, supported by solid macroeconomic data and major political events. Now, however, there are increasingly more signals suggesting that this optimism may be waning..
Debt market anxiety
In recent weeks, analysts have been drawn to the relatively weaker performance of the US stock markets compared to the European markets. The Dow Jones and S & P 500 recorded their biggest declines this year, with the ICE dollar index, which measures the greenback against a basket of major currencies, down 1,7% since the beginning of the year. The dollar's decline may indicate investors are becoming increasingly cautious about the U.S. economy's outlook, while seeing more stability outside the United States.
Concerns are also growing in the debt market, where yields on 2- and 10-year U.S. Treasury bonds have fallen to 2025 lows. Typically, lower yields signal an increase in demand for bonds, suggesting a flight of capital to safe assets in the face of an uncertain future.. This situation often accompanies expectations of an economic slowdown or even recession.
Continued price pressure
The main reason for the deterioration in sentiment remains inflation, which continues to remain above target. Despite earlier aggressive interest rate hikes by the Federal Reserve, the pace of decline in inflation remains unsatisfactory. Americans' inflation expectations have already exceeded 3%, and the 5-year breakeven rate was 2,61%, the highest result in two yearsThe data suggests that market participants do not believe inflation will return to the 2% target anytime soon, which could increase nervousness and prompt a sell-off in riskier assets such as stocks.
The coming weeks will be crucial for financial markets, mainly due to important macroeconomic publications. The report will be released on Friday. PCE, the Fed’s key inflation indicator, whose projected 0,3% m/m increase could confirm continued price pressure. Then, on March 7, labor market data will be released, and on March 12, the CPI inflation reading. If inflation proves difficult to beat, and at the same time, there is a slowdown in job creation and wage growth, the vision of stagflation will become more real.
For the Federal Reserve, this situation poses a serious challenge. Traditionally, the central bank combats high inflation by raising interest rates, but in an environment of weakening growth, such actions could increase the risk of recession. In turn, too lenient an approach to inflation risks perpetuating it, which in the long run could threaten the stability of the economy.
High interest rates for longer?
If macroeconomic data fails to allay investor concerns, pessimistic sentiment could persist in stock markets and liquidity could deteriorate further. Fears of prolonged high interest rates and declining growth could prompt large institutional investors to remain cautious. In such conditions, safe assets such as treasury bonds or gold may become more important at the expense of the stock market..
If the US economy does enter a stagflation phase, it will be necessary to simultaneously combat high inflation and slowing growth. For the Fed and financial market participants, this will be an exceptionally difficult scenario, requiring precise balancing of monetary policy and flexible response to new data. As a result, investors are already preparing for increased volatility, expecting that the upcoming macroeconomic publications and Fed decisions will be key to the future direction of the market.
Source: Krzysztof Kamiński, OANDA TMS Brokers