US inflation jumps 7.5% to 40-year high: What does this mean for investors?

Year-over-year US inflation climbed again in January to 7.5%, ahead of economist forecasts of 7.3% and the highest reading since 1982. 

Inflation increased 0.6% on-the-month in January, and again, ahead of economists forecasts of 0.4%. 

The main drivers of inflation last month were: 

• Fuel oil +9.5% 

• Electricity +4.2% 

• Used cars +1.5% 

• Apparel +1.1%

• Food at home +1.0% 

Top price increases over the last year: 

• Used cars +40.5% 

• Gasoline +40.0% 

• Gas utilities +24% 

• New cars 12.2%

• Electricity +10.7% 

Fed implications 

After the inflation report, US 2-year Treasury yields - which reflect short-term interest rate expectations - jumped from 1.36% to 1.61%. 

The bond market is clearly bracing for near-term rates to be hiked north of 1.0%.

The probability of the US Federal Reserve hiking interest rates by 50 basis points (bps) spiked to 83.1%, up from 24% yesterday and 7% a month ago, according to CME’s FedWatch tool. 

Source: CME Group

Markets hate uncertainty 

Stubbornly high inflation and rate fears drove much of the market’s January selloff, where the S&P 500 fell -10%, the Nasdaq had a -16% drawdown and the ASX hit lows -9.2%. 

The market eventually rebounded, amid a robust US earnings season and the realisation that slightly higher rates does not mean the end of the world. 

The prospect of four 25 bps hikes became the norm and effectively 'priced-in' to market expectations, markets began to rebound.

Enter last night’s inflation reading. 

The likelihood of a 50 bps hike in March has once again mangled expectations.

Investors should brace for more near-term volatility until the market has better view of what's on the horizon.

Technology stocks are expected to bear the brunt of the selling, as rich valuations come under fire and investors take a step away from speculative assets.

Eyes on oil 

The biggest inflationary pressures have been surging oil, shelter and vehicle prices. 

Oil prices are edging towards 8-year highs and driving up other cost factors such as shipping and transportation. 

Oil prices don’t seem like they want to come back down either. 

“The Biden administration reached out to the Saudis but was unable to make any progress in getting oil prices down. The Saudis are sticking to their gradual output increase strategy for now, which means that energy traders will be buying on every oil price dip,” said Oanda senior market analyst, Ed Moya. 

Oil market fundamentals remain “very tight and with no immediate changes to that outlook, crude prices seem poised to go higher,” added Moya. 

Could raising interest rates too quickly hurt the economy first, and then drive oil prices lower? 

As opposed to finding a way around oil prices first, which could alleviate inflationary pressures?

Back at home

RBA Governor Philip Lowe testimony on Friday reiterated the central bank's view to "not increase the cash rate until inflation is sustainably in the 2-3% range."

Lowe said the Board is prepared to be patient, recognising that "there is a risk to waiting but there is also a risk to moving too early."

"It is entirely possible, though, that countries with higher inflation rates will need a bigger adjustment in interest rates than currently anticipated. If so, this could result in an abrupt adjustment in financial conditions."