The US CPI rose to a 40-year high of 7.5% in January as inflation keeps running hot despite economists expecting a print of 7.3%. This is the second time the index hit a 40-year high back-to-back. Analysts had expected inflation to show some signs of weakness. Instead, they now call for Fed to act more aggressively as the month-on-month data showed strength in addition to the yearly figures.

The immediate reaction

Stocks fell hard on the announcement, but they quickly reversed losses to only continue falling afterward. The SPX is down nearly 3%, Nasdaq trades 3.5% lower, and even industrials-heavy Dow is taking a beating 2% below its recent peak.

The 2-year yield, which tracks 2-year rate expectations, soared to 1.65%, whereas the 10-year yield broke to 2-1/2-year highs at 2%. Both found resistance at these levels as markets try to digest the next big move.

Gold lost more than 1% of its value, and oil plunged nearly 3% as the dollar soared, whereas currencies like the euro, pound, and loonie fell around 1% give-or-take as the battle between central banks gets more tense.

Expectations going forward

Persisting higher inflation prompted the Fed to turn somewhat hawkish in January and signal its first rate hike in March. Based on a 40-year inflation record, some analysts thought that the Fed would need to step up its game and hike twice, but the rhetoric dissipated – up until yesterday.

According to CME’s FedWatch Tool, target rate probabilities for the March 16 meeting have ramped up from 7% on Wednesday to a whopping 98.6% following the CPI print. May’s meeting now sees a target rate of 75-100 basis points from a pre-print figure of 11%. And most expectations by year’s end range between the 150-225 basis points, with a mean at 37.1% projecting 2% interest rates. This is eight hikes in 2022 alone. In January, the FedWatch tool showed a 0% probability of that happening.

What will investors do now?

Hiking rates are one of the biggest downside risks to markets, but investors will prefer to watch the US’s GDP and jobs markets. The reality is that as long as the economy grows and the jobs market improves, investors could continue to buy pullbacks.

In the last release, US GDP expanded at 1.7% last quarter, 5.7% up for the year. This was the most significant annual growth since 1984. However, there seems to be an increasing notion that GDP has peaked and will start decelerating. Something all traders must watch.

US’s jobs market is not far from doing great too. Last month, the NFP delivered a massive beat by adding nearly half a million workers to the workforce. But the concern investors will hold close to is that inflation is rising faster than wages. This is a recipe for recession; history has proven. However, the labor market does not flash any alarms yet, evidently seen in the GDP expansion.

Despite the US economy recovering, living costs increase, and supply disruptions add to inflation and inventort build-up. Can central banks fight the future challenge?

What’s next for key markets?

Since the Fed is unlikely to stabilize inflation soon, the US stock faces serious headwinds. In addition, the Biden administration is unlikely to cut back on regulation and taxes, which adds to downside risks. And swiping the House won’t be until November – if there at all.

On the flip side, markets do not crash without real risks having been counted for. Hiking is one of the early signals indeed, but not what could trigger a crash. A recession could trigger a crash. Technically speaking, the GDP will need to contract for two consecutive months. In theory, this might not be what markets read this time around to make a move. That would be the rise in borrowing costs for the government. It might be why the Fed has held a close-mouthed stance about its hiking cycle all along. So, perhaps there is a chance market will keep going up a little more until then.

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