Markets shrug off higher than expected inflation data for now

The key US inflation indicator that markets have been keenly anticipating came and went on Wednesday, and despite an outcome that was feared most by equity investors in the days leading up to the Consumer Price Index (CPI) release, markets have essentially shrugged off the higher-than-expected inflation print.

Rising Inflation

Month-over-month headline consumer prices for January rose by 0.5%, a substantially accelerated pace from December’s +0.1%, and also significantly faster than the +0.3% that was expected for January. Core CPI (excluding food and energy) in January increased at the same pace as December at +0.3%, but was higher than the +0.2% expected. On an annualized basis, headline CPI rose 2.1% versus expectations of 1.9%, while core CPI rose 1.8% versus the 1.7% that was expected.

Overall, Wednesday’s inflation data was indeed substantially higher than consensus forecasts, and it reinforced market fears of higher inflation and interest rates that were recently sparked after the US jobs report earlier in the month showed higher-than-expected wage growth and US government bond yields rose to hit multi-year highs. In turn, these concerns have fueled anticipation that the Federal Reserve could potentially be compelled to raise interest rates at an accelerated pace in order to mitigate the possibility of overheating inflation.

Market Reaction

Due to these inflation and interest rate concerns, the knee-jerk reaction on Wednesday’s release of the CPI data was what might have been expected. US stock futures, which had been rallying from recent lows for the past three days and were positive before Wednesday’s market open, dropped sharply on the open. At the same time, the US dollar surged as gold prices tumbled.

Shortly thereafter, however, markets appeared to shrug off the data as the US trading session progressed – stock markets erased losses as they staged an upside reversal and market volatility rapidly deflated, while the US dollar took a dive to a new weekly low and gold surged sharply to a new weekly high. These swift market reversals after the initial impact of the inflation data began to wear off suggest that anticipation of higher inflation and interest rates was largely already priced into markets. Indeed, that anticipation was one of the driving forces pressuring stocks during last week’s steep market correction. It was also responsible for helping to boost the US dollar during the same period.

Potential Impact

The question now remains as to whether expectations of rising inflation and interest rates will continue to make a strong impact on markets going forward, as both equity and currency markets currently appear to have already priced-in such expectations. Our estimate is that the potential impact may be far from over. Elevated volatility will likely be here to stay at least for the foreseeable future, as markets have not yet fully come to terms with a new global economic environment that will most likely be characterized by rising inflation, higher interest rates, and an end to loose monetary policy. If this is indeed the case, equities could see more pressure going forward as the weak and battered US dollar potentially finds support.