The US inflation report came as a big surprise to many investors as despite solid signals for a drop below 8% (decline in new car sales, falling gasoline prices), headline inflation was quite persistent, inching lower marginally to 8.3%. Core inflation accelerated more than expected – from 5.9% to 6.3%, beating the forecast of 6.1%. The report came as a shock to the market, with expectations of the Fed terminal rate (where the tightening cycle is expected to end) revised up by 25 bp to 4.3%. A pronounced reaction took place in forex and the stock market: the main US stock indices fell by 4-5%, the capitalization of Nasdaq, where assets are the closest substitutes for Treasuries in terms of duration (time-weighted cash flow for the asset), plunged the most. The index erased almost 6%.

The situation is increasingly reminiscent of the 1980s, when high inflation raged in the United States and the then head of the Fed, Volker, raised the rate to 15%, sending economy into recession. Of course, it is now difficult to imagine that the Fed rate could ever be above 10%, nevertheless, the impact of the CPI report on expectations for the Fed terminal rate was significant. The two-year Treasury yield rose to 3.8%, while the ten-year Treasury yield advanced to 3.45%. These are the new yearly highs:

The idea that the Fed may be forced to remove monetary support at a more aggressive pace reinforces expectations that the US economy will face faster deceleration in growth rate, with growth risks spilling over to weaker economies as well. Rising dollar borrowing costs create downside risks for developing countries’ sovereign debt. Based on this, the forecast for developing currencies becomes less favorable – investors may begin to reduce exposure to EM sovereign debt in their portfolios with outflows putting pressure on national currencies.

One of the signs of the late phase in expansion – the yield curve inversion (the spread between the yields of 10 and 2-year Treasury bonds) reached a new extreme point after the release of CPI. The spread was down to -34 bp. The movement of the spread deep into the negative zone is usually accompanied by a strong dollar, as the demand of investors for the US currency as a haven asset increases.

The release of the CPI made it virtually indisputable that the Fed will raise rates by 75bp in September. The market has even begun to price in an outcome where the Fed will raise rates by 100 bp! The chances of this outcome are now 36%:

Investors will also be on the lookout for clues as to how the pace of hikes will change at the meeting following the September decision. It is quite possible that the pace of tightening will remain at the current level of 75 bp.

Other central banks may have to work hard to outpace the Fed in terms of tightening and make local fixed-income assets more attractive to foreign investors. However, considering growth constraints in other economies this looks unlikely. This idea may be the key behind a potential fresh leg of dollar rally. Therefore, it is highly likely that in the near future we will see a retest of 110 points on the dollar index (DXY):