Henry Allen, a strategist at Deutsche Bank AG, argues there is a "fundamental dislocation" between expectations for only modest moves from the Federal Reserve and the European Central Bank and the intensifying forces pushing prices higher. In a note published Monday, he said investors are underestimating the scale of tightening required to get inflation under control. As he put it: "Either inflation needs to fall, or the pressure on rates will continue."
Allen highlights the US ISM services index, noting that costs for inputs - including raw materials - are rising at a rate last observed shortly after the pandemic, a period when US CPI inflation was at 5%. Energy costs have also risen as the conflict in the Middle East persists, while food and metals have jumped amid tangled supply chains and harsh weather that is hitting farmers.
Interest-rate derivatives now imply just two further Fed hikes, scheduled to conclude by the end of July 2027, despite Chairman Kevin Warsh saying last month that inflation isn't meaningfully slowing. "Markets continue to price in a shallow Fed hiking cycle that's inconsistent with how they've behaved in past hiking cycles," Allen wrote, and he said that in four of the last five years, markets have misjudged how forceful policymakers would be.
On the ECB side, traders have been hesitant to add bets on further tightening even after European gas reached its highest level in three years and growth in the euro-zone economy exceeded the initial estimate in the second quarter. Pricing suggests roughly three quarter-point increases by July, about where it stood earlier in the summer.
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Despite hot inflation and a selloff in bonds, credit and equity markets have held up. Allen says that tension cannot last forever. "If the pressure on rates is maintained, that in turn will force an adjustment in risk assets," he wrote. "Something needs to give here, with several asset classes vulnerable to the impact of a more aggressive tightening cycle from central banks."
For your wallet, the takeaway is simple: if rates end up higher for longer than many expect, the easy ride in risk assets may not be as secure as it looks today.
