Dec 8, 2023 - Business

Markets say the battle against inflation is over — and the Fed won

Expected annual inflation over the next five years
Data: FactSet; Chart: Axios Visuals

Global markets think the war against inflation is over. And the Fed won.

Why it matters: Reading the tea leaves from bond, stock and currency markets sheds light on how investors believe the economy will develop next year.

  • It also helps explain the rip-roaring rally in stocks.

The big picture: The overwhelming signal markets are sending right now is that inflation will fall back to the snail's pace of 2% that prevailed before COVID.

  • This is most clear in the market-based reading of inflation expectations — charted above, and often referred to as a "five-year breakeven" — which is now nearly back to 2%.
  • That's the lowest it's been since the pandemic-era inflation issues flared up in 2021.

Zoom out: Participants in some other key markets are singing the same tune.

  • Yields on U.S. government bonds have plunged since the end of September, as investors priced in slowing growth and falling inflation.
  • In the market for Fed funds futures, traders are putting 60% odds that the Fed will declare victory on inflation and cut interest rates in March.
  • Expectations of rate cuts weaken the dollar in foreign exchange markets. The U.S. dollar index is down roughly 2.5% since the end of September.

Between the lines: Those big bets on falling inflation and coming rate cuts have been great for stocks, and help explain much of the S&P 500's nearly 20% gain this year.

  • The benchmark index is up more than 10% since the end of October.
  • The Nasdaq composite — typically more sensitive to rate cuts — is up a tidy 13% over the same period.

Yes, but: Some of the recent certainty about falling inflation may merely reflect the sharp tumble in oil prices over the last couple of months.

  • Benchmark U.S. crude oil futures are down more than 20% since the end of September and have slipped under $70 a barrel, as American production surged and the market shrugged off Saudi Arabia and Russia's efforts to keep prices propped up.
  • Academic studies have found that oil price movements have an outsized impact on inflation expectations, so if oil prices bounce back, some of the disinflationary vibes of the moment could go away.

What to watch: The close collaboration between Russia and Saudi Arabia, which are driving the effort to try to prop up oil prices. Russian President Vladimir Putin visited the Middle East this week amid concerns that the oil price cartel's ability to influence prices is weakening.

Go deeper