(Bloomberg) -- Wall Street got a reality check on Tuesday, with hotter-than-estimated inflation data triggering a slide in both stocks and bonds.
Equities pushed away from their all-time highs as the consumer price index topped estimates across the board. Treasuries sold off, with two-year yields hitting the highest since before the December central bank "pivot." Swap traders ratcheted down their expectations for a Fed cut before July. The stock market's "fear gauge" — the VIX — surged the most since October. And a measure of perceived risk in the US investment-grade corporate bond market soared — with three issuers getting sidelined.
"Today's CPI report caught a lot of people off guard," said Chris Zaccarelli at Independent Advisor Alliance. "Many investors were expecting the Fed to begin cutting rates and were spending a lot of time arguing that the Fed was taking too long to get started – not appreciating that inflation could be sticky and not continue down in a straight line."
The CPI data came as a disappointment for investors after a recent downdraft in price pressures that helped build expectations for rate cuts this year. The numbers also gave credence to the wait-and-see approach highlighted by Jerome Powell and a chorus of Fed speakers.
The S&P 500 fell 1.4%, dropping below 5,000 in its worst CPI day since September 2022. Rate-sensitive shares like homebuilders and banks sank, while Tesla Inc. led losses in megacaps. The Russell 2000 of small caps slumped about 4%. US 10-year yields climbed 14 basis points to 4.31%. The so-called real yield hit 2%. The dollar rose, driving gold under $2,000. In late trading, Lyft Inc. soared on a bullish outlook.
"It is too early to declare victory over inflation," said Torsten Slok at Apollo Global Management. "Maybe the 'last mile' was indeed more difficult."
Zaccarelli at Independent Advisor Alliance noted that the January CPI is only one month's report and if there's a decline in inflation in February, then this will have been just a "bump in the road." However, if we see a new pattern of inflation stalling out at current levels — or increasing from here — then the stock market has further to fall.
Andrew Brenner at NatAlliance Securities expects more volatility for the rest of the week "as the bears have the upper hand and the bulls are grasping."
To Jason Pride at Glenmede, evidence of "still-sticky" services inflation will likely give the Fed pause before cutting rates too quickly.
Swap contracts referencing Fed policy meetings — which as recently as mid-January fully priced in a rate cut in May and 175 basis points of easing by the end of the year — were roiled. The odds of a May cut dropped to about 32% from about 64% before the inflation data, with fewer than 90 basis points anticipated this year.
"While the door for a March cut had already been effectively shut given the recent Fed commentary and the jobs reports, the Fed has now locked the door and lost the key," said Greg Wilensky at Janus Henderson Investors.
Much of the unanticipated increase in CPI was concentrated in what looks like a "noisy jump" in Owners' Equivalent Rent (OER) — a shelter price indicator, according to Tiffany Wilding at Pacific Investment Management Co. While that will likely revert, the details were consistent with the Fed having a "last mile problem" — and not cutting rates until midyear or later, she added.
To Jeffrey Roach at LPL Financial, while the data wasn't exactly what the Fed wanted to see, investors will have to wait until later this month for a more comprehensive look at consumer prices.
"Just as the Fed said it wouldn't rush to cut rates even after several months of encouraging economic data, they're not going to immediately reverse course just because of one hotter-than-expected CPI reading," said Chris Larkin at E*Trade from Morgan Stanley. "Until proven otherwise, the longer-term cooling inflation trend is still in place. The Fed had already made clear that rate cuts weren't going to happen as soon as many people wanted them to. Today was simply a reminder of why they were inclined to wait."
The disinflation process is not a straight line — and one hot print on its own after an extended string of more favorable releases does not represent a new trend, said Josh Jamner at ClearBridge Investments.
The surprise jump in the January consumer price index probably will be less pronounced in the Fed's preferred inflation gauge and potentially less alarming to central bank officials as they weigh when to cut interest rates. Based on the latest CPI figures, the personal consumption expenditures price index excluding food and energy — due from the Bureau of Economic Analysis on Feb. 29 — probably rose 0.29% last month, Morgan Stanley economists said.
"The CPI data has disrupted the string of Goldilocks growth and inflation data that had helped to lift the S&P 500 over 5,000," said Brian Rose at UBS Global Wealth Management. "But it doesn't change our positive fundamental outlook for 2024 of solid growth, further disinflation, and the start of Fed rate cuts in Q2 that is supportive of risk assets."
More Comments on CPI:
Skyler Weinand at Regan Capital:
"Getting to the Fed's magical 2% inflation target may prove more difficult than expected and result in elevated interest rates for a longer period of time."
- Rob Swanke at Commonwealth Financial Network:
"This is certainly not the news that the Fed will be looking for in order to begin cutting rates. So we may be on hold for several more months."
- Paul Toft at Key Private Bank:
"We remain aligned with the Fed's comments of being more cautious in when to start cutting rates, and we believe the first rate cut will not come until the June or July meeting."
- Neil Birrell at Premier Miton Investors:
"We are not at the stage of worrying about inflation reaccelerating, but we are not out of the woods yet either."
- Quincy Krosby at LPL Financial:
"The 'last mile' - as expected - is proving to be stickier and more stubborn inhibiting even the most dovish wing of the FOMC."
- Bryce Doty at Sit Investment Associates:
"From the Fed's perspective, economic growth is strong enough that there isn't a sense of urgency on cutting rates. In the meantime, bond investors will get to enjoy higher yields a little while longer than many thought."
- Jim Baird at Plante Moran Financial Advisors:
"There's still a viable path to a soft landing, but the January inflation report is a reminder that getting there won't be a walk in the park."
- Lauren Goodwin at New York Life Investments:
"Though the timing of a Fed rate cut is uncertain, most investors are betting that a cut is the next move. Investors can consider locking in higher policy rates before Treasuries reflect lower rates in the coming months."
- Alexandra Wilson-Elizondo at Goldman Sachs Asset Management:
"A delayed Fed means a focus on cash rich companies that benefit from higher real wages and a strong consumer, rather than on cyclicals that have indebtedness in floating rate form. For rates, we have kept dry powder for better entry points into the market as it reprices the central bank delay and valuations are more appealing with better risk/reward."
Well ahead of the CPI report, Bank of America Corp. clients posted the largest outflows from US equities in five weeks in the period ended last Friday.
Clients were net sellers of US equities last week, withdrawing $1.9 billion from the asset class — the most in five weeks, BofA quantitative strategists led by Jill Carey Hall said.
Investors are going "all in" on US technology stocks as they turn the most optimistic about global growth in two years, according to a separate survey by BofA.
Allocation to tech is now at the highest since August 2020. Exposure to US equities more broadly has also risen, while easing macro risks prompted investors to trim cash levels by 55 basis points from January. Previous such declines in cash levels were followed by stock market gains of about 4% in the following three months, strategist Michael Hartnett wrote in a note.
US equity futures had a sharp turn to bullish flows in the middle of last week, ending it with $18 billion new longs in S&P 500 futures, according to Citigroup Inc. strategists.
Nasdaq 100 futures also had $7.4 billion new longs, and long positioning on the benchmark is very extended and completely one-sided, a team led by Chris Montagu wrote.
