Stocks plummeted and government bond yields soared on Tuesday, as investors were once again caught off guard by the persistence of inflation in the United States and quickly shifted their views on what the Federal Reserve may need to do to combat rising prices.
It was the latest in a string of surprises that have undercut investors’ optimism and left them rapidly adjusting to a more gloomy outlook on the path for interest rates and the economy.
Consumer prices in the U.S. rose 8.3% in the year through August, a report showed Tuesday, cutting against economists’ expectations and throwing doubt over the belief that inflation had peaked.
The S&P 500, which had been trading higher in the hours before the data was released, slumped 4.3% by the end of the day, its biggest drop since the depths of the coronavirus pandemic in June 2020. The slide stood in stark contrast to gains in recent days. The index had climbed about 5% in the week leading up to the report, as investors had increasingly bet that the Fed would be able to cool inflation without tipping the economy into a severe downturn.
But the faster-than-expected inflation numbers showed that broad-based price pressures remain. Every sector in the S&P 500 index fell as investors reconsidered how much the Fed may need to raise interest rates, which makes borrowing more expensive for consumers and companies. The Nasdaq Composite stock index, which is full of tech stocks that are seen as more sensitive to rising interest rates, fell 5.2%, its worst day since June 2020.
“We are not out of the woods yet,” said Luke Tilley, the chief economist at Wilmington Trust. “We can’t even see the edge of the woods from here.”
Following Tuesday’s drop, the S&P 500 sits 17.5% below where it started the year and about 7% higher than its low point in June.
The day’s turmoil was another upset for investors in a summer characterized by choppy trading and shifting expectations. Better-than-expected earnings, along with some signs that inflation may have peaked, had helped lift stock prices in July and early August. Then, Fed officials, including the central bank’s chair, Jerome Powell, warned that the fight against inflation was not over and that interest rates still needed to move markedly higher, pulling stock prices lower again.
More recently, with a sense that the Fed’s message had been received and that a higher path forward for interest rates had been accounted for, stocks began to rise again. Even before the inflation data was released, investors had come to expect another big rate increase, of three-quarters of a percentage point, when the Fed meets next week.
Expectations are shifting again. Some investors are even starting to price in the possibility that the central bank could lift interest rates by a full percentage point, increasing borrowing costs by the most since 1984. Among them is the Japanese bank Nomura, which in just the past week has shifted from predicting the Fed would lift rates by half a percentage point, to three-quarters, to a full point on Tuesday.
“We continue to believe markets underappreciate just how entrenched U.S. inflation has become and the magnitude of response that will likely be required from the Fed to dislodge it,” the analysts wrote in a research report.
The yield on the two-year Treasury note, a measure of government borrowing costs that is sensitive to changes in the expected path of interest rates, shot higher after the inflation numbers were released, rising above 3.75%, a fresh high for the year.
And the U.S. dollar, which had weakened for days against a basket of currencies representing major U.S. trading partners, swiftly strengthened on Tuesday, gaining 1.4%.
Mike Pond, the head of global inflation-linked research at Barclays, said the surprising inflation data had not altered his view that the Fed would raise rates by three-quarters of a percentage point next week.
“But we do think it will change the tone of what they are going to do going forward,” he said. “This will leave the Fed more concerned.”
Futures prices that reflect investors’ changing expectations for where interest rates will be at the end of the year have quickly jumped higher. They’re now predicting an upper limit of 4.25%, adding an additional quarter-point to previous forecasts and meaning the Fed is expected to raise interest rates another 1.75 percentage points over the next three months.
Some bankers and investors clung to expectations that even with a more rapid pace of rate increases, the Fed may yet stick a so-called soft landing, lowering inflation but avoiding recession. Yet there is also acknowledgment that the Fed’s task has been made harder by stubbornly high inflation.
Solid data on the labor market earlier this month, which pointed to the resiliency of the economy after several rate increases this year, also highlights the challenge of slowing inflation at the same time as unemployment remains low, bolstering consumer spending.
It means that current positive signals for the U.S. economy may perversely foretell more pain to come, said Lauren Goodwin, an economist at New York Life Investments.
“The longer the economy holds on, the longer household balance sheets can withstand these high prices, the more aggressive the Fed has to be in the future,” she said. “Investors were getting too comfortable with the idea that inflationary pressures were easing.”