The stock market was briefly unsettled by CPI report. Here's why.

By Vivien Lou Chen

Fed-funds futures traders still expect a jumbo-size rate cut by year-end, suggesting 'recession fears are rising' in the rates market, strategist says

The moment that financial-participants waited for this week finally arrived, and it came with something of a twist. August's consumer-price index came in close to expectations and reinforced traders' expectations for a regular-size, 25-basis-point interest rate cut from the Federal Reserve next Wednesday. These would ordinarily be welcome developments for stock investors. Instead, stocks fell over much of Wednesday's session - with the Dow Jones Industrial Average DJIA briefly plunging as much as 743.89 points, before ending with its biggest intraday comeback in almost two years - as investors considered whether policy makers may be doing too little, too late to reduce borrowing costs. The fed-funds rate target has been at a 23-year high of 5.25%-5.5% for more than a year. After Wednesday's CPI data, fed-funds futures traders continued to mostly price in at least 100 basis points of rate cuts over the central bank's final three meetings of this year, including the gathering that begins next week - and indicated they still see a larger-than-normal, 50-basis-point reduction occurring in November or December. It all added up to the possibility that the central bank might already be behind the curve, raising questions about its ability to successfully navigate a soft landing for the economy. The number of rate cuts being priced in "suggests recession fears are rising," said Lawrence Gillum, the Charlotte, North Carolina-based chief fixed-income strategist for broker-dealer LPL Financial. "What we're seeing right now is the rates market calling for imminent recession." Via phone on Wednesday, the strategist said "our view is that the economy is slowing, but we don't think it's going to contract, and that the rates market is mispricing the amount of rate cuts that are going to take place. Rate cuts are going to be priced out, eventually, because we don't see a recession occurring in the next few quarters, that's for sure." Wednesday's market reaction offers an example of just how unusual the current trading environment is right now. Aside from CPI data, financial-market participants were also reacting to Tuesday night's televised debate between Vice President Kamala Harris and Republican Donald Trump, with Harris seen as the winner - prompting a rethink of the so-called Trump trade that was supposed to benefit stocks in certain sectors and industries.

Read: The market has pronounced a winner from Tuesday's debate, and it's Kamala Harris

Only a few days ago, some people - like Tom Essaye, founder of Sevens Report Research - said that if Wednesday's CPI inflation report came in weaker than expected and left the door open to a half-percentage-point reduction on Sept. 18, that would be "better for markets" and "generally welcome" news. Meanwhile, market participants such as Jay Hatfield, chief executive of New York-based Infrastructure Capital Advisors, said they would have regarded a 50-basis-point rate cut by the Fed next week as an ominous sign that the U.S. is definitively going into a recession. Instead, neither scenario for a big rate cut next week unfolded. As the market-implied odds of a 50-basis-point reduction tumbled to 15% on Wednesday, investors and traders appeared to be briefly rattled anyway by the prospects of a normal-size, 25-basis-point rate cut this month.Judging by the magnitude of 2024 rate cuts they envision, rates traders seemed to still be operating under the assumption that a U.S. recession should come to fruition. Meanwhile, stock investors appeared to have a slightly different, more roundabout way of thinking soon after Wednesday's data came out: that disinflationary trends in the U.S. are leaving current levels of interest rates too restrictive, which undermines equity valuations and eventually raises the risk of an economic downturn down the road.The S&P 500 SPX bounced back as dip-buyers emerged during Wednesday's session, handing all three major stock indexes their biggest intraday comebacks in up to two years, and as some analysts considered whether a more gradual pace of Fed rate cuts might be in store. Ed Yardeni of Yardeni Research described the initial reaction of stock investors to the CPI report as a "hissy fit.""The outlook remains for further YoY [year-over-year] disinflation ahead," said David Doyle, the Toronto-based head of economics at Macquarie. In a note, Doyle said that "our baseline is for the Federal Reserve to ease at a 25 bps-per-meeting pace ahead, with a total of 200 bps occurring over the next 12 months."Meanwhile, 2- BX:TMUBMUSD02Y through 30-year Treasury yields BX:TMUBMUSD30Y bounced off their 2024 lows as traders assessed the likeliest path for interest rates.

The rates market's statement to the Fed on Wednesday "is crystal clear: By willingly making the decision to do less cutting now....you're going to be forced to do more cutting later," said Charlie McElligott, a cross-asset strategist at Nomura Securities International in New York.In a note, McElligott wrote that "the perception is simply that the Fed's `slow-play easing'-guidance will then act to `self-fulfill' an eventually deeper slowdown, which will then require deeper `Fed behind the curve / policy error' rate cuts."

Joy Wiltermuth contributed.

-Vivien Lou Chen

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09-11-24 1632ET

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