Stocks plummeted and U.S. government bond yields rocketed higher after fresh inflation data undermined investors’ bets over the slowing pace of inflation in August.
The S&P 500 slumped more than 2 percent as trading opened on Tuesday. Stocks had nudged higher in recent trading sessions, rising 1.1 percent on Monday and nearly 5 percent over the past week, as investors increasingly bet on the Fed’s ability to lower inflation by raising interest rates without slowing the economy to the point of tipping it into a severe downturn.
But higher-than-expected August inflation data released on Thursday wrong-footed investors, sending stocks lower and prompting a rapid re-pricing of how much the Fed may need to raise interest rates to rein in rising prices.
“We are not out of the woods yet. We can’t even see the edge of the woods from here,” said Luke Tilley, chief economist at wealth manager Wilmington Trust.
The two-year Treasury yield, which is sensitive to changes in the forecast path of interest rates, shot higher after the numbers were released, rising as high as 3.74 percent and marking a fresh high for the year.
Solid data on the labor market earlier this month pointed to the resiliency of the economy after several rate increases this year. Coupled with policymakers’ persistent message that they have yet to complete their task of lowering inflation through higher rates, investors had already come to expect another big rate increase, of three-quarters of a percentage point, when the Fed meets next week. For a time, some had bet on a half-point increase as the more likely option.
Following the inflation data, bets that the Fed would move aggressively when policymakers meet next week solidified, with some even starting to price in the possibility that the central bank could raise rates by a full percentage point, which would be its largest rate increase since 1984.
Futures prices that show investors expectations for where interest rates will be at the end of the year also jolted higher, to nearly 4 percent, as investors bet on an additional quarter-point raise from the Fed by December.
And the U.S. dollar, which had weakened for four days straight against a basket of currencies representing America’s major trading partners, swiftly strengthened.
Mike Pond, the head of global inflation-linked research at Barclays, said the surprising inflation data had not altered his view that the Fed will raise rates by three-quarters of a point next week.
“But we do think it will change the tone of what they are going to do going forward,” he said. “This will leave the Fed more concerned.”