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The Tell: Inflation expectations key as investors weigh prospect of 100 basis point Fed rate hike, strategist says

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A hotter-than-expected June consumer inflation reading this week has some traders penciling in a full percentage point increase in the Federal Reserve’s interest rate later this month, but a strategist at LPL Financial said investors should wait for more evidence that inflation will remain sticky, and Friday’s measure of 5-year inflation expectations is what she is counting on. 

“We wait for that and see whether or not that has climbed higher,” said Quincy Krosby, chief equity strategist at LPL Financial in a phone interview, referring to data due from the University of Michigan. “If it has, the Fed will probably bring 1% on the table for discussion, or what we’ll see is probably they’ll have to invoke 75 basis points longer than they thought.”

The June consumer-price index came in hot on Wednesday with the year-over-year increase of 9.1% reaching a 41-year high. After the release, the markets have seen a rising chance of a 100 basis point rise in the country’s benchmark interest rate at the Fed’s meeting in less than two weeks, though those expectations moderated on Thursday. 

Traders of fed-funds futures tied to the Fed’s policy rate on Wednesday priced in a higher than 80% probability of a full percentage-point rate rise at the meeting, up from 7.6% on Tuesday, according to the CME FedWatch Tool. The likelihood reflected in the market dropped to 44% after Federal Reserve Gov. Christopher Waller on Thursday said he still supports a 75 basis point interest rate hike, but left the door open for a larger move if data over the next two weeks comes in strong.

Read more: Fed will have ‘zero patience’ for high inflation readings and some economists expect them to get more aggressive

That’s why Friday’s preliminary release of July’s consumer sentiment and 5-year inflation expectations are widely watched, according to Krosby. The University of Michigan’s June data showed consumers expected inflation to rise at a 5.3% annualized rate, and the 5-year inflation outlook rose slightly to 3.1% from 3% in the previous month but decreased from its midmonth reading of 3.3%. The overall consumer sentiment fell to a record low, hitting 50 in June. 

“The only reason I keep mentioning the University of Michigan report, not the consumer sentiment part, but the five year expectations for inflation part, is that the Fed itself mentioned, and he (Chairman Powell) said that, coupled with the CPI report, made the Fed question whether or not they can actually wait six weeks for a 75 basis point hike,” Krosby said. “So I think we do need to see more evidence that is climbing higher.” 

While investors wonder if the aggressive rate increases could bring down consumer prices, the strategist said there are signs inflation is nearing a peak.

“You’re seeing the supply chain challenges beginning to ease — and remember the Fed can only deal with demand — but it is an equation and when the supply chain challenges ease to the point that they normalize and begin to function, instead of just frozen, it should start helping to bring prices down,” said Krosby. 

“Markets should see prices coming down in the second half, and the economy should slow to a level that dampens inflation and demand,” according to Krosby. “So it’ll be a weak period going into the election, then the election, and a strong return in the market three months following that.”

Read more: Presidential election cycle shows that stock market may bottom in the third quarter before rally in the fourth, analyst says

U.S. stocks traded lower on Thursday, with the Dow Jones Industrial Average
DJIA,
-0.46%

tumbling 600 points in early morning trading before ending well off session lows. The S&P 500
SPX,
-0.30%

ended with a loss of around 0.3%, while the Nasdaq Composite
COMP,
+0.03%

eked out a gain of less than 0.1%.

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