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Traders who had been positioning for the central bank to hike only once more “- in March “- are suddenly being confronted with wagers on at least three more rate increases. Image Credit: AP

New York: The worst week in 2023 for stocks and bonds saw investors coming to the grips with the idea that the Federal Reserve may indeed have to keep rates higher for longer as it wages a war against inflation.

Wall Street has recalibrated bets on the Fed’s peak rate to around 5.2 per cent, from under 5 per cent earlier this month, amid a barrage of hawkish remarks from US officials that followed a hot jobs print. And that’s not all. Traders who had been positioning for the central bank to hike only once more “- in March “- are suddenly being confronted with wagers on at least three more rate increases.

That’s why Tuesday’s consumer price index is seen as a litmus test for the Fed’s ability to knock down inflation amid the most-aggressive tightening cycle in decades. Core CPI will either point to the obvious need for the Fed to push further into restrictive territory or reflect the progress it’s made toward securing the anchor of inflation expectations, said Ian Lyngen at BMO Capital Markets.

Recalibrated expectations

“The new year’s bullishness has quickly faded as investors recalibrated forward expectations in the wake of the employment report,” Lyngen added. “As it presently stands, investors are biased for an upside surprise versus the consensus for core-CPI of +0.4 per cent on a monthly basis.”

Treasury 10-year yields climbed to around 3.75 per cent. Interest-rate options activity Friday included a large, apparently new, position that will profit if the rate reaches 4 per cent within a week’s time. The rise in yields weighed heavily on the tech space, with the Nasdaq 100 underperforming major gauges. The S&P 500 ended with a small gain Friday “- but posted its worst week since December.

“It’s healthy to have these corrections along the way,” said Alec Young, chief investment strategist at MAPsignals. “Expectations are much more realistic about the Fed.”

After an indiscriminate risk rally that defied Fed hawkishness, sober-minded traders are upping their hedging game at long last.

The cost of contracts protecting against a 10 per cent decline in the largest exchange-traded fund tracking the S&P 500 is now 1.7 times more than options that profit from a 10 per cent rally. This so-called put-to-call skew is hovering at the highest level since August 2022, when a two-month rally abruptly reversed.

Global equity outflows

Meantime, global equity funds had outflows of $7.4 billion in the week through February 8, according to a Bank of America Corp. note that cited EPFR Global data. Cash funds also saw redemptions at $10.1 billion, while $7.4 billion entered bonds.

On the economic front, US consumer sentiment climbed to a more than one-year high in early February as more upbeat views of current conditions outweighed lingering concerns about the outlook.

In corporate news, Lyft tumbled the most on record after forecasting dramatically lower profits than expected and saying it will cut prices in an attempt to attract and keep customers. Expedia Group executives gave an optimistic outlook for travel demand in the current quarter, reassuring investors after the company’s fourth-quarter results were weaker than expected.

America’s largest banks are unlikely to return share buybacks to prior levels anytime soon given tougher-than-usual Fed stress tests, according to Wells Fargo analyst Mike Mayo. The assumptions in this year’s test, published by the Fed on Thursday, “seem tougher, and they are made so as the economy nears a recession,” he said.