Markets bank on Fed remaining on hold

The S&P 500 reached a record high and US 10-year yields fell last week despite a further increase in US inflation. US consumer price inflation rose at a 5% annual rate in May, the highest year-over-year increase since 2008. Core CPI (excluding food and energy) prices rose by 3.8%, the most rapid rate since 1992.

But despite the higher inflation data, equities rallied and bond yields fell.

The S&P 500 rose 0.5% on Thursday and 0.2% on Friday to close at a record high, while US 10-year nominal yields declined by 6 basis points (bps) on Thursday before rebounding slightly on Friday. In our view, the following factors explain this market reaction:

• The data support the Fed’s view that inflation is not broad-based and is likely transitory. Components including used cars and airfares, equivalent to just 14% of the core CPI index, accounted for almost two-thirds of May’s increase. The impact of low base effects, such as energy prices, will ease in the coming months. By the end of the year, even if Brent rises to our forecast of USD 75/bbl, the direct influence of oil prices on US consumer price inflation will almost halve. The shift back toward services as the economy reopens could also ease price pressures on lockdown beneficiaries like home furnishings, car prices, and recreational goods.
• The market appears to be taking the Fed at its word. On the day of April’s 4.2% CPI print, real yields rose by 5bps on concerns the Federal Reserve would withdraw monetary accommodation earlier than expected. Since then, Fed policymakers have reinforced their message that they would look through a transitory spike in inflation. Real yields declined after the May CPI data was released last Thursday. Attention will now shift to this week’s FOMC meeting for further clues about the Fed’s intentions.
• The labor market is key to a shift in Fed policy. Fed Chair Jerome Powell has made it clear that substantial progress toward full employment is a precondition for a shift in Fed policy. After payroll growth for March was initially estimated at 916,000, Powell said: “We want to see a string of months like that, so we can really begin to show progress toward our goals.” While some labor market indicators point to strength—such as the quit rate and the JOLTS data—April and May payroll data have fallen far short of the 1 million mark the Fed wants to see. As enhanced unemployment benefits are withdrawn, schools reopen after the summer, and vaccinations increase the confidence of older workers to rejoin the labor force, we believe payrolls will increase more rapidly, but this will not be for several months.

We share the Fed’s view that the rise in inflation will be transitory. We expect US 10-year yields to resume their rise as the economy fully reopens and payroll growth picks up, and we have an end-year forecast of 2%. We see further upside for equities, and think cyclical areas of the market, like energy and financials, should outperform. Click here for more on positioning for reflation.

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