U.S. financial markets are bracing for a more aggressive Federal Reserve and a deeper economic downturn following the latest inflation data.
The Dow Jones Industrial Average plunged by more than 800 points, the S&P 500 dropped by nearly 3 percent, and the Nasdaq Composite Index plummeted by more than 400 points.
Treasury yields were green across the board, with the benchmark 10-year yield up by nearly 13 basis points to 3.17 percent. The two-year note also climbed by 22 basis points to a 14-year high of at least 3 percent.
Traders also poured into the greenback as the U.S. Dollar Index (DXY), a gauge of the dollar against a basket of currencies, rallied past 104.00 on June 10.
Investors responded to the consumer price index (CPI) soaring to a 40-year high of 8.6 percent in May, topping market forecasts of 8.3 percent. Markets ostensibly believe that the U.S. central bank will be more hawkish on policy tightening.
Christian Hoffmann, a portfolio manager and managing director at Thornburg Investment Management, said three 50-basis-point rate hikes have been priced into the market, sending the benchmark Fed funds rate to nearly 3 percent by year's end.
"Hopes for a September ‘pause’ have evaporated," Hoffman said.
“The Federal Reserve must demonstrate progress on inflation. High data prints are painful and leave noses bloody at the Federal Reserve and White House. Continued high inflation does nothing to decrease anxiety and volatility in capital markets, forcing investors to grapple with the three-headed monster of inflation, recession, and monetary policy.”
According to Ed Yardeni, president of Yardeni Research, the intense selloff is "signaling that investors now expect that the Fed will have to raise the federal funds rate by another 200bps over the next 12 months."
“The 10-year yield remained around 3.10 percent, suggesting that the yield curve is anticipating a significant economic slowdown, which will lower inflation,” Yardeni wrote in a note to clients.
Could the U.S. central bank hike the benchmark rate by 75 basis points at next week's Federal Open Market Committee (FOMC) policy meeting? Jonathan Miller, senior U.S. economist at Barclays, thinks it's possible since the CPI data are showing no signs of easing price pressures.
Two-thirds of survey participants anticipate a quarter-point increase in September. One-quarter believe the FOMC will pull the trigger on a 50-basis-point rate hike.
Looking ahead, Mohamed El-Erian, a top economist and chief economic adviser at Allianz, anticipates that next month's headline figure will be worse than the June month-over-month reading.
In addition to more interest rate hikes, the odds of a recession have increased in the wake of the CPI data, according to Nancy Tengler, CEO and CIO at Laffer Tengler Investments.
"The numbers are catastrophically bad for Americans and the policy makers in Washington," she wrote in a research note. "As we have been arguing this is sticky, persistent inflation that will take years to work out of the system.
"Futures sold off as the numbers were digested and the yield curve flattened. Odds of a recession in 2023 have gone up in our estimation."
Although Tengler is optimistic about consumers since employment is high and they have accumulated savings from the COVID-19 pandemic, new data suggest that households might struggle to cushion the blows of inflation and a recession.
Merk Investments' numbers suggest that the $2.6 trillion created in excess savings in 2020 and 2021 combined are beginning to be withdrawn. The monthly savings pace is also below pre-pandemic levels.
Consumers aren't optimistic about this economy, as the University of Michigan's Consumer Sentiment Index collapsed to just higher than 50 in June, much lower than the market estimate of 58.
Ultimately, the headline inflation data are proving that inflation is proving to be stickier than policymakers and the markets had anticipated.
The next key data print will be on June 14 when the producer price index will be released. The market is penciling in a 10.9 percent reading.
"Indeed, there is a risk that both fiscal and monetary policy will over-tighten and drive the U.S. economy into recession in 2023 or early 2024," Nick Reece, a Portfolio Manager at Merk Investments, wrote in a research note.
In the first quarter, gross domestic product contracted by 1.5 percent.
A recession is technically defined as two consecutive quarters of economic contraction.