Behind this year’s improved start for markets lies a broad wager that inflation will soon post a once-in-a-generation decline.
Market-based gauges of inflation expectations project the annual pace of rising prices will tumble in the months ahead roughly as fast as during the recession that followed the 2008 financial crisis—or when Fed Chairman Paul Volcker used double-digit interest rates to crush the soaring inflation of the late 1970s.
Hopes for a quick return to 2% inflation have encouraged bets that the Federal Reserve will pause and even reverse its interest-rate increases this year. Rate increases pummeled stocks and bonds in 2022, and a possible respite has sent both higher in January. The rally has extended to some of the riskier assets that had stung investors hardest last year, such as bitcoin and the ARK Innovation exchange-traded fund, known for its focus on fast-growing tech companies.
Stock gains continued on Monday, when the S&P 500 rose 1.2%, led by advances in the tech sector. The tech-heavy Nasdaq Composite gained 2%, adding to the recovery among shares that suffered most as rates increased last year.
Many Wall Street strategists, however, are warning that a painless end to elevated inflation will be difficult to achieve. Previous episodes of inflation suggest that it rarely falls as fast as markets are now forecasting that it will in the absence of a serious recession.
Economic data released last week showed signs of weakening consumer demand. More companies are laying off workers and reducing their earnings estimates. Meanwhile, China’s economic reopening and a still-tight labor market both add inflationary pressure that could prompt Fed rate increases beyond those currently expected.
Avoiding a serious downturn while inflation falls quickly would be a “Goldilocks scenario,” said Liz Ann Sonders, chief investment strategist at Charles Schwab. “Pretty much everything would have to go right,” she said.
For now, markets are holding relatively steady. Despite wavering last week, the S&P 500 has gained 4.7% so far in 2023. Bonds have rallied. Treasury yields and derivatives markets are both reflecting bets that the consumer-price index will rise by about 2% through next January.
At Monday’s close, U.S. Treasury notes set to mature in January 2024 were yielding around 4.7%, while inflation-protected Treasurys that come due the same month were yielding about 2.7%, according to Tradeweb. The difference between those figures, called the break-even inflation rate, suggests that Treasury traders are betting the consumer-price index will rise by about 2% over the next 12 months.
Wagers on contracts known as CPI swaps, another way of betting on future inflation rates, show traders forecasting inflation of roughly 2.2% in the next year.
Those figures, if realized, would represent a historically rapid decline.
In June, the year-over-year increase in the CPI hit 9.1%, the highest since the early 1980s. If inflation falls to 2% by next January, that roughly 7-percentage-point decline would closely compare to a similar-size drop that played out between August 2008 and July 2009, when inflation declined to minus 2.1% from 5.6%—in the midst of a historic recession.
Before that, inflation hadn’t fallen so fast within 20 months since Mr. Volcker’s early-1980s rate-increase campaign. The previous episode came as the economy normalized after the start of the Korean War.
Bob Michele, chief investment officer for J.P. Morgan Asset Management, cautioned that it is premature to assume that inflation will continue an orderly drop through the rest of the year. If it flares up again, the Fed could resume raising rates, he believes. Mr. Michele is telling clients to avoid vulnerable debt investments.
“There are a lot of reasons for the Fed to pause and see what happens, but there are also a lot of reasons they may have to go and keep hiking,” Mr. Michele said.
Monica Defend, head of asset manager Amundi’s research institute, is also concerned the inflation consensus is too optimistic. She projects that the annual rate will fall no lower than 4% in the next 12 months. Amundi is advising a cautious approach to equities.
“We don’t believe that 2% is a feasible target right now,” Ms. Defend said.
Since 2021, traders’ year-ahead inflation bets have persistently underestimated how fast prices have actually risen. Last year’s unexpected inflation surge sent the Fed rushing to tame rising prices, prompting rate increases that helped send the Nasdaq down 33% in 2022.
The last three months, however, have brought renewed optimism for cooling inflation and an end to the Fed’s increases as soon as March. December’s 6.5% inflation rate was the lowest since late 2021. The Fed slowed the pace of its rate increases in that month and is widely expected to do so again on Feb. 1.
Rosy assumptions have helped assets that were badly bruised last year get off to a brisk start in 2023. The ARK Innovation ETF, a fund that bets heavily on growing technology companies, has gained more than 21% so far this year. The tech-heavy Nasdaq Composite, which slumped worse than other indexes last year, is now outgaining them. Even bitcoin has rallied after a calamitous 2022, rising 39% versus the dollar so far this year.
More sedate sectors have also been boosted by assumptions of a painless end to soaring inflation. Home-building stocks have climbed since mid-October, even though Wall Street analysts have slashed their estimates for the industry’s future profits, Ms. Sonders of Schwab has observed. Last year, rate increases hit the housing market hard by making mortgages more expensive.
Analysts who expect CPI inflation to rapidly cool this year point to a big fall in energy prices since the summer, as well as easing price increases for food and some commodities in recent months.
But even if inflation declines as fast as traders now predict, stocks may struggle anyway if the economy lists into a recession as inflation falls.
One classic recession warning light has been flashing since this past summer. For months, yields on short-term Treasurys have held above those on longer-term debt, a reversal of the norm and a signal investors expect slowing growth and rate cuts in the future.
That provides a strong reason to doubt the sustainability of the current stock rally, said Chris Verrone, head of technical and macro research at Strategas.
“We can’t be blindly long risk assets when the yield curve does not yet suggest that we’re on the other side of this,” Mr. Verrone said.