The stock market’s reaction to Thursday’s latest inflation report underscored how confused and fearful investors are.
The S&P 500 SPX,
plunged as much as 3% shortly after opening as September’s consumer price index showed inflation accelerating. Shortly before noon, stocks reversed direction and the benchmark ended the day up 2.6% in one of the biggest reversals on record.
Nick Sargen, an economist at Fort Washington Investment Advisors with decades of experience at the U.S. Treasury, Federal Reserve and Wall Street banks, spoke to MarketWatch about the unexpected rise in inflation, his outlook interest rate spikes and greater risk to financial markets. The interview is edited for clarity and length.
Market surveillance: What did you think of the CPI numbers this morning?
Sargent: I expected the overall year-over-year figure to go down. It hasn’t gone down as much as me, and most of the other people, we were expecting. I expected the year-over-year number to drop to around 7% by the end of the year.
Market surveillance: It can still happen.
Sargent: It’s possible, but have you filled up with gas? Two weeks ago, the regular price had dropped to $3.15. Now I filled up at $3.59 because of the OPEC+ effect. What we had going for us was a big drop in gas prices.
What people have underestimated is the service component, which is [showing unexpectedly high price increases]. Month-over-month, some of the more volatile measures were down, but the services component is going the other way. This is partly the housing component.
As mortgage rates rise, house prices should fall. But the CPI measures the imputed rental rate. Core inflation is going to stay higher, longer – it’s not just the house price effect, it’s the mortgage effect multiplied by the price effect. It works through the system with a lag.
Market surveillance: The Federal Open Market Committee has already raised the federal funds rate by 0.75% following each of the last three policy meetings, to its current range of 3.00% to 3.25%. What do you expect from the FOMC after the November 1-2 meeting and until the end of the year?
Sargent: The market is convinced that the Fed will make another 75 basis point rate hike on November 2. It’s kind of stuck. We are now talking about December. Maybe they’ll bring it back to [an increase of] 50 [basis points] in December. I think they wanted to increase it to 4.5% by the end of the year — it’s built into the cake.
Market surveillance: What maximum fed funds rate do you expect for this cycle?
Sargent: Maybe 5.5%.
Market surveillance: What will happen to the long end of the US Treasury yield curve if the fed funds rate hits 5.5%? [On Oct. 13, the yield on two-year U.S. Treasury bills
was 4.48%, while the yield on 10-year Treasury notes
was 3.96%. A “normal” yield curve means yields increase as maturities lengthen.]
Sargent: My hunch is that the whole curve would move up, but it would be even more inverted than it is today. We now have a slight inversion. Many people believe that an inverted curve is one of the best warning signs of a recession. The current curve shows that the market expects the economy to weaken. The market is now valued at a federal funds rate of 4.5%.
Market surveillance: What do you think of some views expressed by fund managers and in the financial media that the Federal Reserve is moving too fast with interest rate hikes and shrinking its bond portfolio?
Sargent: The Fed, in my opinion, was the main culprit for inflation, because it kept rates too low for too long and continued to inflate the balance sheet.
The Fed made a serious error in judgment on inflation last year. They attributed everything to supply chain disruptions and COVID. They said it was temporary. It was wrong. In September 2021, Federal Reserve Chairman Jerome Powell started talking about longer-than-expected inflation. He was clearly changing his tone. He was reappointed by President Biden in November. The big surprise was waiting to raise rates and reduce bond purchases.
Because they’ve waited so long, they have to catch up, and there’s always the risk of you overdoing it.
Market surveillance: What could trigger a bond crash in the US, similar to the one we saw recently in the UK?
Sargent: You talk about financial instability. The biggest risk that none of us can see is the exposure of financial institutions and who is in debt. It’s scarier and it could cause the Fed to stop the tightening cycle – if it smells good, a major financial institution is in trouble.
This is clearly the lesson of [the bond-price action in the U.K.]. The Bank of England is fighting against inflation and, as a result, must save the pension funds. They are against the grain.
With Credit Suisse CS,
we have a European institution in difficulty. It’s not systemic unless it leaks into other institutions. My opinion here is that US bank balance sheets are much less leveraged than they were in 2007.
What could cause the Fed to stop tightening sooner would be some kind of concern about systemic financial risk.
Market surveillance: Could we have a liquidity crisis in the United States?
Sargent: I don’t really foresee it in the United States, because we are the refuge of the world. Everyone is talking about the stock market. But it’s the worst US bond market [for year-to-date total returns] in history.
What is the best performing asset in the United States? The US dollar. It’s super strong. Is everything okay here? No, but I will take the American economy over the European or Japanese economies. China is no longer the locomotive it used to be. President Xi Jinping has done more damage to China’s economy than anyone since Mao.
So I don’t see any liquidity risk in the US It would be outside of the US
Don’t miss: The stock market is in trouble. This is because the bond market is “very close to a crash”.