To The Moon

Inflation expectations will also be key to market direction: analysts

Investors want to see signs that inflation is peaking. Oli Scarff/Agence France-Presse/Getty Images

With the U.S. stock market showing some stability after stumbling to start 2022, inflation data due Thursday understandably looms large. But it probably won’t be the last word, market watchers warned.

Investors will also be paying close attention to measures of inflation expectations, including a reading that will round out the week on Friday, as they size up the Federal Reserve’s likely response to persistent price pressures.

“I can only hope for a ‘no gasp’ week in terms of the data. U.S. CPI is expected to be significantly hotter than the previous month, so I don’t expect any real rattling of markets unless it comes in above expectations,” said Kristina Hooper, chief global market strategist at Invesco, in a note, referring to the January consumer price index.

Economists surveyed by The Wall Street Journal look for January CPI to show a 7.2% year-over-year rise after a 7% December increase that was the hottest in nearly 40 years. CPI is expected to show a 0.4% monthly rise, slowing from the 0.5% rise in December. The core index, which strips out volatile food and energy prices, is also expected to rise 0.4%, which would bring its year-over-year rise to 5.9% versus 5.5% in December. The data is set for release at 8:30 a.m. Eastern on Thursday.

The Federal Reserve, which previously played down rising inflationary pressures as “transitory,” has signaled it will likely begin lifting interest rates in March, followed by a reduction in the size of its balance sheet, as it responds to price pressures.

Rattled markets

Treasury yields have risen sharply since the start of the year, sparking a stock-market selloff led by tech and other growth stocks that are more sensitive to rates. The yield on the 10-year Treasury note earlier this week neared 2% for the first time since 2019, but has since pulled back.

Major benchmarks have bounced strongly this week as investors appeared ready to buy the market’s January dip. The tech heavy Nasdaq Composite remains down 7.4% for the year to date. The S&P 500 is down 3.8% and the Dow Jones Industrial Average has declined 1.6%.

‘Stop going up’

So what would it take for stocks to fully regain their footing?

“Inflation has to stop going up. I know that sounds overly simplistic, but the bottom line is that for the past several months, markets and the Fed have seen ‘hints’ of a peak in inflation pressures, yet that wasn’t reality,” said Tom Essaye, founder of Sevens Report Research, in a Wednesday note.

While the year-over-year rate has been rising due to seasonal factors — a year ago vaccine uptake wasn’t widespread and the global economy hadn’t reopened — “the bottom line is that at some point inflation needs to peak and recede, otherwise the Fed will get even more hawkish, and markets will get hit again,” he said.

Expectations are key

Essaye and Invesco’s Hooper agree that investors won’t only be parsing Thursday’s CPI data for clues. Inflation expectations are also crucial, ensuring that investors will pay close heed to the University of Michigan’s preliminary February read onthe subject Friday morning.

That data could, in fact, prove more important, Hooper said, after the New York Fed’s inflation-expectations for the next one and three years remained elevated in December, but appeared to peak. The data showed median expectations one-year expectations unchanged at 6% and three-year expectations steady at 4%.

“We would want to see the same from the Michigan data,” she said, noting that January data from the New York Fed won’t be seen until Monday.

Essaye is less sanguine about the outlook, noting that all the measures of inflation expectations monitored by his firm are in areas that indicate the Fed needs to be hawkish, even with five-year inflation breakevens pulling back from recent highs.

In order “to get a ‘dovish surprise’ from inflation this week, we need CPI and inflation expectations to show signs of peaking,” he wrote.