Powell’s Soft-Landing Dream In Danger as Traders Hedge Inflation

Signs that inflation has yet to release its grip on markets have simmered for weeks. Now they’re boiling over after Wednesday’s hotter-than-forecast consumer price index sent stocks and bonds reeling.

With gold, oil and cryptocurrency rallying of late amid fresh demand for inflation hedges, the March CPI report unleashed a rout across Wall Street. The S&P 500 dropped as much as 1.3%, touching its lowest level in three weeks, while yields on 10-year Treasuries jumped to the highest since November. Energy companies were the best-performing names, a reminder of the post-pandemic playbook when inflation trading was ascendant.

With the commodity rally stoking broader cost pressures, a cohort of traders is starting to doubt that Federal Reserve Chair Jerome Powell will be able to engineer a soft economic landing, where the business cycle expands at a healthy clip just as inflation eases.

One view gaining traction instead: That this year’s cross-asset run-up — including the multi-trillion-dollar stock boom — is itself working against the Fed’s inflation-fighting mission by encouraging largess among consumers and investors.

“A key problem for the Fed is that these asset price gains are occurring with the economy at full employment, and still growing moderately,” said Doug Ramsey, chief investment officer at Minneapolis-based Leuthold Group. “The stock market’s celebration of looming rate cuts actually puts those cuts in jeopardy.”

stocks and bonds tumble

After the consumer price index topped forecasts for a third month, stocks with weak finances bore the brunt of selling as the specter of a prolonged period of elevated interest rates added pressure to valuations. An index of unprofitable technology firms dropped 3.4% while the Russell 2000 index of small-caps sank 2.5%.

In the bond market, conviction that price pressures have yet to be wrung from the economy is starting to blare in the yield difference between Treasuries and inflation-linked Treasuries. So-called two-year breakeven rates jumped back to 2.9%, while the one-year version hit 4.3%, both well above the Fed’s own target of 2%.

With stocks and bonds moving increasingly in tandem, investors have been forced elsewhere for protection. Hedge fund managers have boosted their bullish gold bets to the highest level in four years, weekly CFTC data on futures and options showed prior to the CPI report. Money managers raised Brent, WTI oil net-long positions to the most bullish in more than six months.

“Given the positive correlation between equities and fixed income, this makes a dangerous set up for the long 60/40 portfolio,” wrote Goldman Sachs Group Inc. tactical specialist Scott Rubner in an note earlier this week. “Our desk has seen a resurgence in commodity trades to hedge.”

rebounding us wealth

While Powell has repeatedly stressed that financial conditions are weighing on the economy, many market-based measures suggest otherwise. Stocks have added $12 trillion in value since October alone, contributing to readings in a gauge of financial conditions tracked by Bloomberg that are looser now than before the Fed began tightening.

Meanwhile price appreciation in residential real estate is making well-heeled Americans feel ever-richer — encouraging these consumers to loosen their purse strings in a way that might offset the central bank’s inflation-fighting campaign.

Plotting the trend in American households’ net worth against CPI, Gavekal Research found the two have tracked each other pretty closely over the past three decades.

“As households’ net worth rises relative to their existing rate of nominal consumption, the wealth effect can inspire people to ‘live a little,’” Gavekal researchers wrote in a note. “If supply doesn’t keep up with the resulting increase in demand, consumer inflation could accelerate.”

realative value

While pricing pressures mean higher input costs, many companies, particularly large firms, have managed to pass on extra charges to customers, riding the wave of inflation to record profits.

With banks slated to unofficially kick off first-quarter earnings this week, their results will be watched closely to see whether growth can justify an S&P 500 price-earnings ratio that’s roughly 20% above its 10-year average. At 21 times profits, that translates to an earnings yield of 4.8%, a multiple that looks increasingly unfavorable with 10-year Treasury yields rising to 4.5%. In fact, the valuation edge by stocks now sits near the smallest in two decades.

“Equities have ignored rising rates for some time, but today is a wake-up call,” said Emmanuel Cau, head of European equity strategy at Barclays Plc. “The hot CPI print today prompted a reversal in the popular momentum trade and rotation towards inflation hedges.”


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