Bets on big Fed rate hikes are fading in the wake of Russia’s invasion of Ukraine even as oil, food and gas price increases stoke faster inflation concerns.
Russia’s invasion of Ukraine, potentially the biggest military conflict on European soil since the Second World War, has global stocks plunging, oil prices soaring and safe-haven assets in hot demand.
It may also create a new, and potentially more serious, problem for the Federal Reserve.
With U.S. crude topping the $100 per barrel mark for the first time since 2014 on the expectation of sanctions on Russian crude exports, wheat prices rising to the highest levels in a decade over fears for the fate of Ukraine grain crops and companies from Amazon (AMZN) – Get Amazon.com, Inc. Report to Walmart (WMT) – Get Walmart Inc. Report and Ford (F) – Get Ford Motor Company Report warning that supply chain disruptions are likely to last well into the second half of the year, hopes for a quick retreat in domestic inflation is fading fast.
Fast, in fact, describes the current pace of domestic consumer price increases: the Commerce Department said earlier this month that January inflation surged 7.5% from last year, the highest in four decades, powered powered largely by airfares and rental costs.
Bets on an aggressive reaction from the Fed — which dropped its ‘transitory’ narrative late last year — accelerated quickly, with odds of a 50 basis point rate hike in March rising to as high as 66%.
Stock Market Today – 2/24: Stock Futures Plunge Amid ‘Full Scale’ Russian Invasion Into Ukraine
Fed officials have done their best to talk down that suggestion, indicating a preference for measured — and data driven — increases over the coming year, but, at least until yesterday, analysts at JPMorgan were advising clients to expect nine consecutive increases from Chairman Jerome Powell and his colleagues, a series of hikes that would take the Fed Funds rate to between 2.5% and 2.75%.
That’s not happening now.
“The Federal Reserve was very unlikely to do a 50 basis point rate hike for liftoff at its March meeting anyway, but the Russia/Ukraine cements liftoff to, at most, 25 basis points,” said Jamie Cox, managing partner for Richmond, Virginia-based Harris Financial Group.
While U.S. growth was pegged at 7% over the final three months of last year earlier today, the Atlanta Fed’s GDPNow foresting tool says the economy is only likely to expand 1.3% this quarter. And that pace is likely to slow further if consumer sentiment is soured by an extended conflict between Washington and Moscow.
In the bond market, the yield gap between 2-year and 10-year notes — a reliable recession indicator — is trading at just 37 basis points, the lowest levels since the pandemic trough of April 2020.
According to a study from the San Francisco Federal Reserve, an inverted yield curve has preceded all of the nine recessions the U.S. economy has suffered since 1955, making it an extremely accurate barometer of financial markets sentiment.
At the same time, elevated U.S. crude prices will add further pressure to domestic gasoline costs, which are already averaging $3.55 per gallon, and squeeze middle-and-lower income families whose post-Covid savings are starting to erode as government support payments fade.
“A new spike in energy costs is a significant risk economic activity and with that, for corporate profits. Its not time to be panic in stock market … but this hurts sentiment and especially earnings. This means more downside is likely,” said Steen Jakobsen, chief investment officer at Saxo Bank.
That could be why bets on a 50 basis point Fed rate hike have fallen to around 10% in overnight trading, according to the CME Group’s FedWatch tool, even as the arithmetic reality of faster near-term inflation has escalated as a result of the Russia Ukraine crisis.
Others, however, think the Fed’s rate hike path won’t be swayed by either a spike in oil prices or a prolonged Russia Ukraine crisis.
“WTI at $100 or even $120 would not be an existential threat to the U.S. post-Covid economic recovery. It’s not even clear that it would depress economic growth at all,” said Ian Shepherdson of Pantheon Macroeconomics.
“Headline U.S. inflation will be a bit higher, for a bit longer, than our pre-invasion forecasts, but the big picture is little changed,” he added.
