Stocks fell and government bond yields rose on Tuesday, as investors were once again surprised by persistent US inflation and quickly changed their views on what the Federal Reserve might have to do to combat rising prices.
It was the latest in a string of surprises that undermined investor optimism and left them quickly adjusting to a more bleak outlook on the path of interest rates and the economy.
US consumer prices rose 8.3 percent In the year through August, Tuesday’s report showed a cut that missed economists’ expectations and cast doubt on the belief that inflation had peaked.
The S&P 500, which had been trading higher in the hours before the data was released, fell 4.3% by the end of the day, its biggest drop since the depths of the coronavirus pandemic in June 2020. The slide stopped in stark contrast to the gains in recent days. The index rose about 5 percent in the week leading up to the report, as investors increasingly bet that the Federal Reserve would be able to cool inflation without pushing the economy into a severe recession.
But faster-than-expected inflation figures showed that broad-based price pressures remain. Every sector in the S&P 500 fell as investors reconsidered how much the Fed might need to raise interest rates, making borrowing more expensive for consumers and businesses. The Nasdaq Composite, filled with technology stocks seen as more sensitive to higher interest rates, fell 5.2 percent, its worst day since June 2020.
“We are not out of the woods yet,” said Luke Tilley, chief economist at the Wilmington Trust. “We can’t even see the edge of the forest from here.”
After Tuesday’s decline, the S&P 500 was 17.5 percent lower as it started the year and about 7 percent above its June low.
Today’s turmoil was yet another annoyance for investors in a summer of volatile trading and shifting expectations. Better-than-expected earnings, along with some signs that inflation had peaked, helped lift stock prices in July and early August. Then Federal Reserve officials, including the head of the central bank, Jerome H. Powellwarned that the fight against inflation is not over and interest rates still need to rise significantly, causing stock prices to fall again.
Recently, with the feeling that the Fed’s letter had been received and that a higher path forward for interest rates had been calculated, stocks started to rise again. Even before the inflation data was released, investors had been expecting another big rate hike, by three-quarters of a percentage point, when the Federal Reserve meets next week.
Expectations are changing again. Some investors are even pricing in the possibility that the central bank will raise interest rates by a full percentage point, raising borrowing costs by the most since 1984. Among them is Japan’s Nomura Bank, which just last week switched from expecting the Fed to raise rates. By half a percentage point, to three-quarters, to a full point on Tuesday.
“We continue to believe that markets are underestimating how entrenched inflation is in the United States and the extent of the response likely to be required from the Fed to remove it,” the analysts wrote in a research report.
The yield on the two-year Treasury, a measure of government borrowing costs sensitive to changes in the expected path of interest rates, rose after the release of inflation figures, rising above 3.75 percent, a new high for this year.
The US dollar, which has been weak for days against a basket of currencies that are the main trading partners of the United States, quickly strengthened on Tuesday, rising 1.4 percent.
Mike Bond, head of global inflation research at Barclays, said the surprise inflation data did not change his view that the Federal Reserve will raise interest rates by three-quarters of a percentage point next week.
“But we think it will change the tone of what they are going to do in the future,” he said. “This will make the Fed more concerned.”
Futures prices rose, reflecting investors’ changing expectations of where interest rates will be at the end of the year. They now expect a cap of 4.25 percent, adding an additional quarter point to the previous forecast and meaning the Fed is expected to raise interest rates by another 1.75 percentage points over the next three months.
Some bankers and investors clung to expectations that even with a faster pace of interest rate increases, the Fed might stick to a so-called soft landing, bringing down inflation but avoiding a recession. However, there is also an acknowledgment that the Fed’s task has been made more difficult by stubbornly high inflation.
Strong data on the labor market Earlier this month, which signaled the resilience of the economy after several price increases this year, also highlights the challenge of slowing inflation at the same time that unemployment remains low, boosting consumer spending.
This means that the current positive signals for the US economy may inversely predict more pain ahead, said Lauren Goodwin, an economist at New York Life Investments.
“The longer the economy lasts, the longer household budgets can tolerate these high rates, the more aggressive the Federal Reserve will have to be in the future,” she said. “Investors have been very comfortable with the idea that inflationary pressures are abating.”