Dow, S&P 500, Nasdaq have worst days of year after August CPI inflation report

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Fed Chair Powell delivers stark inflation message

Federal Reserve Chair Jerome Powell delivered a stark message Friday: The Fed will likely impose more large interest rate hikes in coming months and is resolutely focused on taming the highest inflation in four decades. (Aug. 26)

AP

A little bump in inflation prompted a steep decline Tuesday in the stock market. 

Following Consumer Price Index report, which showed that inflation edged up by 0.1% last month versus expectations that it fell by the same magnitude, stocks closed sharply lower.

The Dow Jones Industrial Average ended the day down 1,276 points, or 3.9%. Tuesday was the worst day for the index since June 2020. The S&P shaved 178 points, or 4.3%. While the tech-heavy Nasdaq Composite closed down a whopping 633 points, or 5.2%. 

Bond yields, which rise when bond prices fall, jumped. The yield on the 10-year note was 63 basis points higher at 3.4% when markets closed. While yields on the 2-year note rose by 181 basis points to 3.8%.

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CPI inflation report

The Labor Department reported Tuesday that sharply lower prices for gas and cheaper used cars slowed U.S. inflation in August for a second straight month, but prices for food surged.

Excluding the volatile food and energy categories, so-called core prices jumped 0.6% from July to August, higher than many economists had expected and a sign of inflation’s persistence.

Almost all of Wall Street came into the day thinking the Fed would hike its key short-term rate by a hefty three-quarters of a percentage point at its meeting next week. But the hope was that inflation was in the midst of quickly falling back to more normal levels after peaking in June at 9.1%.

The thinking was that such a slowdown would let the Fed downshift the size of its rate hikes through the end of this year and then potentially hold steady through early 2023.

Tuesday’s report dashed some of those hopes. Many of the data points within it were worse than economists expected, including some the Fed pays particular attention to, such as inflation outside of food and energy prices. Markets honed in on a 0.6% rise in such prices during August from July, double what economists expected.

“This suggests that inflation expectations may be becoming ingrained,” said Gargi Chaudhuri, head of investment strategy at iShares.

How high will the Fed raise rates? 

Investors are pricing in more hefty rate hikes in the coming months. Recently many investors were optimistic that the Fed would back off its tight monetary policy stance since inflation appeared to turn a corner.

But August’s CPI report painted a contrary picture. Now the Fed is all but certain to at least hike interest rates by 75 basis points next week. That’ll put interest rates at 3 percentage points higher since the Fed began hiking rates in March. 

After that hike, the U.S. central bank is expected to hold rates steady through the first half of 2023.

The inflation figures were so much worse than expected that traders now see a one-in-five chance for a rate hike of a full percentage point by the Fed next week. That would be quadruple the size of the usual move, and no one in the futures market was predicting such a hike a day earlier.

Traders now see a better than 60% likelihood the Fed will pull its federal funds rate all the way up to a range of 4.25% to 4.50% by March. A day earlier, they saw less than a 17% chance of such a high rate, according to CME Group.

The Fed has already raised its benchmark interest rate four times this year, with the last two increases by three-quarters of a percentage point. The federal funds rate is currently in a range of 2.25% to 2.50%.

Effects of more rate hikes

Higher rates hurt the economy by making it more expensive to buy a house, a car or anything else bought on credit. Mortgage rates have already hit their highest level since 2008, creating pain for the housing industry. The hope is that the Fed can pull off the tightrope walk of slowing the economy enough to snuff out high inflation, but not so much that it creates a painful recession.

In the stock market, all but 16 of the stocks in the S&P 500 fell. Technology and other high-growth companies fell more than the rest of the market because they’re seen as most at risk from higher rates.

Tuesday’s data puts hopes for such a “soft landing” under more threat. In the meantime, higher rates also push down on prices for stocks, bonds and other investments.

Investments seen as the most expensive or the riskiest are the ones hardest hit by higher rates. Bitcoin tumbled 7.1%.

In the stock market, all but four of the stocks in the S&P 500 fell. Technology and other high-growth companies fell more than the rest of the market because they’re seen as most at risk from higher rates.

Apple, Microsoft and Amazon all fell more than 4% and were the heaviest weights on the market. The communication services sector, which includes Google’s parent company and other internet and media companies, sank 4.8% for the largest loss out of the 11 sectors that make up the S&P 500 index.

To be sure, the losses only return the S&P 500 close to where it was before its recent winning streak. That run was built on hopes that Tuesday’s inflation report would show a more comforting slowdown. The ensuing wipeout fits what’s become a pattern on Wall Street this year: Stocks fall on worries about inflation, turn higher on hopes the Fed may ease up on rates and then fall again when data undercuts those hopes.