Fed Rise Triggers Nervy Markets

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US inflation pick up tests market nerves

US inflation picked up in January, with the personal consumption expenditure (PCE) price index rising by the most in a year.

Investors are keeping a close eye on US consumers prices as higher inflation threatens to derail the current bull market in equities.

This bull market is looking long in the tooth in any case, already the second longest in history.

Rising prices

On Thursday, data released by the US Commerce Department showed the PCE had risen to 0.4% in January versus 0.1% in the prior month.

Over the 12 months to the end of the January, the PCE rose by 1.7%.

The core measure, which is the Federal Reserve´s (Fed) preferred inflation measure, and widely cited in its interest rate policy decisions, rose 0.3% in January and 1.5% year on year.

This core measure excludes volatile food and energy components.

Interest rates

The Fed sets its interest rate policy to target a PCE core rate of 2%.

Although inflation is on the up then, it still remains below target.

At the same time, January´s core PCE reading was in line with consensus forecasts.

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Many economists however expect the PCE to breach the Fed´s target at some point this year.

With the Fed having already forecast three 0.25% rate hikes for 2020, investors are worried that it could raise rates by as many as four times.

Dismal month

February turned out to be a dismal month for equities, with the US market as measured by the blue-chip S&P 500 index falling by 3.9%, its worse monthly performance in over two years.

Chief among the market´s concerns was rising inflation and the pace of rate tightening.

Higher interest rates push up bond yields and result in higher borrowing costs for US consumers and businesses.

Historically, rate tightening tends to negatively impact on the both the US economy and the equity market.

Of course, higher rate expectations are supportive for the dollar, with the greenback having risen by nearly 2% as measured by the US dollar index since the beginning of February.

The inflation worries mean that news flow which at other times is viewed as positive for stock markets is currently being construed as negative.

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In this environment, strong US economic data that could point to yet more upward pressure on prices, swaying the Fed´s hand towards higher rates, is potentially a negative.

Tight conditions in the US labour market threaten to push up wages further, putting more upward pressure on inflation in general.

Wages increased 0.5% in January compared with a 0.4% rise in the prior month.

This factor, coupled with the stimulus of Donald Trump´s $1.5tn in tax cuts, explains why many economists expect the PCE to breach the Fed´s 2% target at some point in 2020.

Other data released on Thursday showed claims for US state unemployment benefit had dropped to their lowest levels since 1969.

It is further evidence of the ongoing strength in the US labour market.

Consumer spending

On the other hand, inflation by itself could have a negative impact on US growth.

While US consumer prices are on the up, spending appears to be waning as people see their real disposable incomes squeezed.

Consumer spending, which accounts for the largest slice of US economic activity, grew by 0.2% in January, down from 0.4% in December.

The January reading was also the smallest gain for consumer spending since last August.

Adjusted for inflation, consumer spending actually fell 0.1% in January, the first decline on this measure in 12 months.

On Tuesday, stock markets were hit by relatively hawkish comments from newly installed Fed Chair Jay Powell, with some economists raising their expectations for Fed rate tightening in 2020 as a result.

Perhaps conscious that he may have unwittingly spooked markets, on Thursday Powell appeared to adopt a more dovish tone.

Powell told a US Senate panel on Thursday there was “no evidence that the economy is currently overheating”.

More volatility

Overall, what´s worrying investors at present isn´t so much that US inflation is hurtling out of control ; instead, they see the beginning of the end of the “goldilocks” scenario that pervaded during 2020.

The goldilocks scenario of accelerating economic growth but subdued inflation could never last.

There is however one silver lining to all this. For traders, there´s likely to be plenty of opportunities on both the upside and downside as market volatility continues to rise.

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Fed Rise Triggers Nervy Markets

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