US inflation data for July showed growth above analysts' expectations. This strengthened the arguments in favor of a possible interest rate hike by the Federal Reserve.
The personal consumption expenditures (PCE) price index, which the Fed uses as its primary gauge, rose 3,7% on an annual basis. A month earlier, the indicator stood at 3,6%. The regulator's target is 2%.
Core PCE, which excludes volatile food and energy components, remained at 3,3% — no improvement compared with June. The US Commerce Department published these figures on Wednesday.
The Fed has held its key rate in the range of 3,50–3,75% since December of last year. The regulator's chair, Kevin Warsh, has repeatedly stated his intention to bring inflation back to target, but has not specified whether a rate hike would be needed to do so.
"In the United States, inflation is still a problem," noted Heather Long, chief economist at Navy Federal Credit Union. "The latest data give Warsh time to observe, but he needs to be clearer about which indicators he is watching and what exactly would trigger a rate hike."
Markets reacted quickly. Federal funds futures now price in about a 44% probability of a rate hike in September, versus 36% just before the data release. Traders are fully confident that the rate will eventually be raised by the end of the year.
What does this mean for the stock market (equities)?
Overall – negative, especially for certain sectors:
- Growth and technology stocks: They suffer the most. Their valuation is built on expectations of high profits far in the future. With a high Fed rate, those future cash flows are discounted at a higher percentage, sharply reducing their current fair value.
- More expensive borrowing: It becomes more expensive for companies to borrow money to expand their business, which reduces margins and growth rates.
- Declining consumer demand: High rates make loans more expensive for households as well (mortgages, auto loans, credit cards), which slows the economy and reduces companies' revenues.
- Exception: The financial sector (banks) may benefit in the short term, as they can earn on a wider spread between lending and deposit rates.
3. What does this mean for the bond market?
- Prices of existing bonds fall: There is an inverse relationship between a bond's price and its yield. If the Fed raises rates, new bonds are issued with higher coupons. For old bonds with low coupons to remain attractive, their market price must decline.
- Rising yields on US Treasuries: This is the global benchmark for all other rates in the world.
4. What does this mean for the US dollar (USD)?
- Strengthening: Higher yields on dollar-denominated assets attract foreign capital. Investors sell other currencies to buy dollars and place them in high-yielding US instruments. The dollar index (DXY) tends to rise.
5. What does this mean for cryptocurrencies and other risk assets?
- Downward pressure: Cryptocurrencies (Bitcoin, Ethereum, etc.) have in recent years behaved like "growth assets" with high volatility. When the Fed raises rates, liquidity (cheap money) leaves the markets. Investors shift capital from high-risk assets into safe ones that yield guaranteed returns.
