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Market Extra: Financial markets ran with ‘peak inflation’ narrative again. Here’s why it’s complicated.

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Financial markets grabbed hold of Tuesday’s U.S. softer-than-expected producer-price report and ran with it, driven by the underlying narrative that inflation may have hit its peak and is only set to ease further from here.

Investors and traders can hardly be blamed for cheering Tuesday’s developments considering the euphoria that accompanied last Thursday’s smaller-than-anticipated gains in the consumer-price index, which sent the Dow Jones Industrial Average up by 1,201.43 points in a single day. After Tuesday’s PPI report, stocks initially bounced back from Monday’s lower finish, though Dow industrials relinquished gains in the afternoon. Yield-starved investors jumped into Treasurys again and the ICE U.S. Dollar Index
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briefly dropped by as much as 0.5%. Oil futures touched their lowest prices in three weeks, then shook off early losses, as traders weighed prospects for demand.

Here’s why assessing the most likely path forward for inflation is more complicated than it might appear, though.

Of all the possible scenarios that could play out, the one in which inflation falls but doesn’t head toward 2% fast enough is perhaps the most underappreciated risk in financial markets, according to money managers, economists, and strategists interviewed by MarketWatch. The end result would be that Federal Reserve officials may be forced to push interest rates even higher than most people currently imagine and to keep them there for as long as needed, even if inflation shows signs of gently easing, they said.

Read: Fund managers are overwhelmingly forecasting stagflation next year with no one anticipating Goldilocks scenario

October’s data is a “good” start, but “if financial conditions ease up and consumer spending remains strong because people think the inflation problem is solved, we’re just going to go back to where we were” with aggressive rate hikes, said Eric Sterner, chief investment officer at Apollon Wealth Management, which manages $2.5 billion and is based in Mount Pleasant, South Carolina. “We’re going to be under restrictive interest-rate levels for a while, and if we get a year of inflation around 7% — I don’t think we will, but if we do— that would be enough to put a 6% fed-funds rate on the table.”

“I’m still advising our individual clients to maintain a risk-off approach in their portfolios and to be still invested in the market, but to be more focused on quality stocks like utilities and healthcare and to stay away from technology names or small caps with no solid earnings history,” Sterner said via phone on Tuesday.Stock Market Today: Live coverage of Tuesday’s market action

Investors initially cheered the latest sign of easing price pressures in the October producer-price index, which rose a scant 0.2%, by sending all three major U.S. stock indexes higher — led by a 1.2% rise in the Nasdaq Composite Index during the New York afternoon — though Dow industrials turned lower as trading wore on. Less than a week ago, the Dow
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scored a 1,201.43-point gain and its best single-day performance in more than two years after a softer-than-expected consumer-price index report produced a 7.7% annual headline inflation rate. It was the first below-8% reading in eight months and although policy makers favor other price gauges, it’s the annual headline rate that can impact household expectations.

By nature, financial markets are more focused on the next big event than the nuances of the inflation debate, and the Federal Open Market Committee’s final meeting of the year on Dec. 13-14 looms large. Fed funds traders are back to pricing in an 81% chance of a 50-basis-point rate hike in December and just a 19% chance of another aggressive 75-basis-point increment that’s prevailed since June. Traders do not yet see any likelihood of a 6% fed-funds rate in 2023, though policy makers will have one more CPI and PPI report in their hands by their December meeting and may need even more data to confirm where they’ll need to go with rates.

“The big question in my mind is whether (Fed Chairman Jerome) Powell is steadfast in getting inflation back to 2% or whether he can ease off somewhere around 3%,” said Sterner of Apollon Wealth. Last week’s reaction to October’s CPI data was “way overblown and anyone who jumped on it is going to be disappointed. In my eyes, it’s going to be another bear market rally with a dead-cat bounce.”

The last time financial markets grabbed hold of the peak-inflation narrative was in August, after July’s CPI report and PPI report produced downside surprises. Producer prices resumed their rises and although the annual headline CPI rate has drifted lower, other elements within September’s consumer-price index pointed to persistent inflation and even October’s CPI is not yet enough to move the needle.

“The name of the game for a lot of this year is that there may be improvement, but not at a sufficient pace,” said Will Compernolle, senior economist for FHN in New York. “Inflation could keep getting lower, but if it takes five years to get to 2%, that won’t be to the Fed’s liking. Officials will have some patience, but can’t wait forever. The result is that the Fed keeps hiking and gets more aggressive,” pushing the fed-funds rate target closer to 6% from a current level between 3.75% and 4%, even if it might contemplate a 25 or 50 basis point cut late next year assuming inflation improves.

Since October, FHN has had the view that the terminal fed-funds rate, or level at which the Fed stops hiking rates, is likely to be 6%, Compernolle said via phone.

See also: A 6% fed-funds rate? Some investors say the risk is there, bringing the prospect of more painful Treasury selloffs

The difference with the peak-inflation narrative this time around versus the one that unfolded over the summer is that the inflation could indeed show further signs of easing, analysts said. The problem is that it needs to ease quickly, not gradually, in order to really move the dial.

“Markets reflect human psychology and can get caught up in the moment, and at the moment are going to live and die by the data,” said Rob Daly, director of fixed income for Glenmede Investment Management in Philadelphia, who oversees $4.5 billion. “As we saw with the July data reading for CPI, inflation was not moderating as quickly in the next few months and the blip was quickly corrected. So I’m hesitant to say both the October readings for CPI and PPI are a sign of something concrete. The most important inflation fight going on right now is in shelter, which doesn’t fluctuate, and services, which are tied to wages and stubborn to bring down.”

Glenmede’s fixed-income team has been on the sidelines “waiting for good entry points,” while holding cash and shorter-duration bonds, and has been looking to buy longer-duration debt at higher yields, Daly said via phone. The 60%/40% mix of stocks and bonds “was dead before and is coming back, and having the safety valve of fixed income is something we haven’t seen in a while, especially when yields are so much better.”

Still, “it’s premature to think this one encouraging month of data means everything is on a downswing” with inflation, Daly said. “I’m not ready to say we are out of the woods. I want to engage with the market slowly and get back in. I do think for pockets of the market, it’s a good time to put capital to work, but you have to be tactical and pragmatic in terms of putting money to work. There is value out there.”

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