On Wednesday, tension is mounting in global financial markets as the U.S. prepares to release its May Consumer Price Index (CPI) report. With energy prices soaring due to the Iran conflict, inflation is expected to accelerate, prompting the bond market to begin factoring in potential Federal Reserve (Fed) interest rate hikes later this year.
Market analysts anticipate the May CPI to show a 4.2% year-over-year increase, surpassing April’s 3.8% and marking the highest growth rate since April 2023.
The sharp rise in gasoline prices is the primary driver. The Iran war and the Strait of Hormuz blockade have caused a spike in global oil prices, likely pushing overall inflation higher.
Core CPI, which excludes volatile food and energy prices, is projected to rise 2.9% year-over-year, up from April’s 2.8%, reaching its highest level since September last year.
Wall Street’s focus has shifted from raw inflation figures to the Fed’s interest rate trajectory. Last week’s stronger-than-expected U.S. May non-farm payrolls report has all but eliminated hopes for rate cuts. Instead, the bond market is now pricing in the possibility of rate hikes this year.
A Reuters poll of 102 economists found that 72 (about 70%) expect the Fed to maintain its current benchmark rate of 3.50-3.75% for the rest of the year. This marks a significant increase from just a month ago when less than half predicted a rate freeze.
Tom Porcelli, chief economist at Wells Fargo, told Reuters that it’s extremely challenging for the Fed to justify a rate cut in the current climate. Unless the Iran conflict ends abruptly, discussions about rate cuts are unlikely to gain traction.
Philip Marey, U.S. strategist at Rabobank, noted that the risks are tilting towards more persistent inflation, fewer rate cuts, and even potential rate hikes. The optimistic scenario has essentially evaporated.
The bond market is already showing signs of preparing for a hawkish shift. Bloomberg reports a recent surge in trades betting on rate increases in the Secured Overnight Financing Rate (SOFR) options market, which is sensitive to Fed policy rates.
The interest rate futures market has almost fully priced in at least one 0.25 percentage point rate hike by year-end.
The bond market has struggled this year. Since the outbreak of the Iran conflict, U.S. Treasuries, typically seen as safe-haven assets, have faced selling pressure, causing 10-year yields to spike (indicating falling bond prices).
However, Constantin Bait, portfolio manager at PIMCO, the world’s largest bond fund, suggests that bonds are approaching their most attractive price levels in years, potentially offering better investment opportunities than stocks.
Market watchers believe the upcoming CPI report could significantly influence financial market direction. If inflation comes in higher than expected, bond yields may rise further, potentially putting downward pressure on New York stock prices.
Analysts predict that artificial intelligence (AI) semiconductor and tech stocks, which have recently faced overvaluation concerns, could be hit hardest.
Conversely, a lower-than-expected CPI could partially unwind recent bets on rate hikes, potentially leading to a rebound in Treasury prices and a relief rally on Wall Street.
However, the market’s base case remains a prolonged period of stable rates, or Higher for Longer. While the upcoming Federal Open Market Committee (FOMC) meeting on June 16-17, the first under Chair Kevin Walsh, is likely to keep rates unchanged, investors are keenly focused on potential shifts in the policy statement and dot plot that might signal a retreat from rate cut expectations.