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Market Extra: Sudden realization that inflation may persist is starting to dawn on many U.S. investors

Once-complacent U.S. financial markets, priced for a benign economic outlook for much of the past year or more since the pandemic started, are due for a readjustment as investors start to factor in more persistent inflation than previously thought, some analysts argue.

Whether it’s the image of cargo piling up at California ports, record energy prices in Europe, China’s electricity curb, or crude oil settling at levels not seen since 2018 earlier this week, many are waking up to the idea of price gains that last much longer than Federal Reserve policy makers have led on.

Much of the reassessment is still going on in investors’ minds and hasn’t yet been fully priced in, as evidenced by five-year breakeven inflation rates hovering around 2.5% for the past three months.

But the rethink has gained momentum in recent days — given Federal Reserve Chairman Jerome Powell’s comment that some supply-side bottlenecks have “gotten worse,” and growing inflation concerns from the Bank of England and a number of European Central Bank policy makers. Uncertainty about whether Powell will serve another term and the makeup of the Federal Open Market Committee’s voters in coming years is adding to questions about whether the Fed can stick to its current rate-hike forecasts.

“Markets are extremely vulnerable to any added disruptions to the recovery, and the idea of inflation persisting is slowly becoming the consensus,” Edward Moya, senior market analyst for the Americas at Oanda Corp., said via phone. “Investors are now not as convinced that we’re going to see a Fed that will be able to stand pat and keep interest rates as low as they are.”

Prior to last year’s arrival of COVID in the U.S., the nation was in the midst of its longest economic expansion in history and yet still unable to generate inflation sustainably above the Fed’s 2% target. Until now, the thinking was that the U.S. would likely return to its pre-COVID pattern of low inflation even after economic growth normalizes, with the central bank struggling to hit its inflation objective.

Even after surprisingly strong, year-over-year consumer price readings of 5% or more arrived for May, June, July and August, investors and traders chalked up some of the gains to the base effects of COVID-related shutdowns the prior year, which would eventually drop out of calculations.

The recent delayed reaction by investors to a hawkish pivot by the Fed has been on full display since the Fed’s Sept. 22 policy update, when officials signaled that tapering of monthly purchases could begin in November and they penciled in a 2022 interest rate hike. The bond market was the first to react, sending Treasury yields on their way to the highest levels in months — while stocks sold off on Monday and Tuesday, and the U.S. Dollar Index
DXY,
+0.63%

rose to an almost one-year high by Wednesday.

A similar sequence of reactions may play out in financial markets through the end of the year and into early 2022, as more persistent inflation gets priced in, according to Gregory Faranello, executive director of AmeriVet Securities and head of U.S. rates trading and strategy in New York, and Tom Nakamura, a currency strategist and co-head of fixed income at AGF Investments in Toronto.

The fixed income and commodities sectors would likely be the first places to reflect the readjustment toward more persistent inflation and/or expectations — followed by stocks, which could experience greater volatility, and the U.S. dollar, which would likely climb, they said. From there, a higher dollar would then spill over into emerging markets, which rely heavily in dollar-denominated debt.

The bond market, in particular, has been operating for months under the assumption that inflation would largely remain under control. A buildup of inflation expectations going forward would likely lead to a rise in U.S. breakeven rates across the board, Nakamura said via phone Wednesday. In addition, it would lead to parts of the Treasury yield curve initially steepening as long-end rates shoot up, before ultimately flattening on fears that the Fed may be behind the curve and might need to tighten more aggressively, which would hurt the U.S. recovery, he said.

Read: Does the bond market have it wrong about inflation?

At AmeriVet Securities, Faranello said that he sees inflation coming in at around 2.5% to 3% going forward, as measured by the personal consumption expenditures measure, compared to the Fed’s forecast of 2.2% to 2% between 2022 and the longer term.

“I’m of the camp that some of the inflation will be transitory, but not all of it, and I do think inflation is going to run higher than the Fed has forecast,” Faranello said in an interview with MarketWatch. “The risks are skewed to the upside.”

On Wednesday, the S&P 500
SPX,
+0.58%

and Nasdaq Composite indexes
COMP,
+0.29%

were on their way toward recovering from this week’s selloffs. Meanwhile, yields, including the widely watched 10-year yield
TMUBMUSD10Y,
1.541%

was around 1.54% after hitting the highest levels in months on Tuesday.

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