Stubborn Inflation and Market Mispricing
It is becoming clear that inflation is not returning to the 2% target, but is instead settling in the mid-2% range. The most recent May CPI report showed core inflation remains sticky at 2.9%, which confirms that price pressures are not easing quickly enough. This persistence is happening even as the economy and corporate earnings remain surprisingly strong. Given these conditions, we see a mispricing in the interest rate futures market. The market is currently pricing in only a small 20% chance of a rate hike by September, which seems far too low given the risk that the Fed will need to act. We should consider positioning for higher short-term rates, as the current monetary policy is clearly not restrictive enough to finish the job.Investment Implications and Market Opportunities
The stock market appears complacent, with the VIX volatility index hovering near a low of 14. This presents an opportunity to buy protection cheaply before the market wakes up to the possibility of higher rates. We believe put options on rate-sensitive indices are attractive, as strong Q1 GDP growth of 2.5% could easily be undermined by a more hawkish Fed later this year. This environment also signals strength for the US dollar. If we are concerned that higher interest rates will be necessary, the dollar stands to benefit against currencies with more dovish central banks. A long position in the dollar is a logical hedge against the domestic policy tightening we anticipate. We have seen this pattern before, such as in late 2021, when the market was slow to price in the Fed’s aggressive pivot to fighting inflation. The latest jobs report, which added a solid 210,000 jobs while the unemployment rate held at 3.8%, gives the Fed a green light to stay tight. We should not be caught off guard again and must prepare for a potential repricing of risk across asset classes.Start trading now — click here to create your real VT Markets account.
