Investors are obsessed with size of Fed’s next rate hike. Here’s what they’re missing.

Debate has been simmering over whether Federal Reserve policy makers will raise the fed-funds rate by three-quarters of a percentage point later this month, as they did in June, or step up their inflation-fighting campaign with a full point hike —- something that hasn’t been seen in the past 40 years.

Friday’s economic data, which included somewhat improving or steady inflation expectations from the University of Michigan’s consumer survey, prompted traders to lower their expectations for a 100 basis point hike in less than two weeks. The size of the Fed’s next rate hike might be splitting hairs at this point, however, given the bigger, overwhelming issue confronting officials and financial markets: A 9.1% inflation rate for June that has yet to peak.

Generally speaking, investors have been envisioning a scenario in which inflation peaks and the central bank is eventually able to back off aggressive rate hikes and avoid sinking the U.S. economy into a deep recession. Financial markets are, by nature, optimistic and have struggled to price in a more pessimistic scenario in which inflation doesn’t ease and policy makers are forced to lift rates despite the ramifications for the world’s largest economy.

It’s a big reason why financial markets turned fragile a month ago, ahead of a 75 basis point rate hike by the Fed that was the biggest increase since 1994 — with Treasurys, stocks, credit and currencies all exhibiting friction or tension ahead of the June 15 decision. Fast forward to present day: Inflation data has only come in hotter, with a greater-than-expected 9.1% annual headline CPI reading for June. As of Friday, traders were pricing in a 31% chance of a 100 basis points move on July 27 — down significantly from Wednesday — and a 69% likelihood of a 75 basis point hike, according to the CME FedWatch Tool.

“The problem now does not have to do with 100 basis points or 75 basis points: It’s how long inflation stays at these levels before it turns lower,” said Jim Vogel, an interest-rate strategist at FHN Financial in Memphis. “The longer this goes on, the more difficult it is to realize any upside in risk assets. There’s simply less upside, which means any round of selling becomes harder to bounce back from.”

An absence of buyers and abundance of sellers is leading to gaps in bid and ask prices, and “it will be difficult for liquidity to improve given some faulty ideas in the market, such as the notion that inflation can peak or follow economic cycles when there’s a land war going on in Europe,” Vogel said via phone, referring to Russia’s invasion of Ukraine.

Financial markets are fast-moving, forward-looking, and ordinarily efficient at evaluating information. Interestingly, though, they’ve had a tough time letting go of the sanguine view that inflation should subside. June’s CPI data demonstrated that inflation was broad-based, with virtually every component coming in stronger than inflation traders expected. And while many investors are counting on falling gas prices since mid-June to bring down July’s inflation print, gasoline is just one part of the equation: Gains in other categories could be enough to offset that and produce another high print. Inflation-derivatives traders have been expecting to see three more 8%-plus CPI readings for July, August and September — even after accounting for declines in gas prices and Fed rate hikes.

Ahead of the Fed’s decision, “there will be dislocations across assets, there’s no other way to put it,” said John Silvia, the former chief economist at Wells Fargo Securities. The equity market is the first place those dislocations have appeared because it has been more overpriced than other asset classes, and “there aren’t enough buyers at existing prices relative to sellers.” Credit markets are also seeing some pain, while Treasurys — the most liquid market on Earth — are likely to be the last place to get hit, he said via phone.

“You have a lack of liquidity in the market and gaps in bid and ask prices, and it’s not surprising to see why,” said Silvia, now founder and chief executive of Dynamic Economic Strategy in Captiva Island, Florida. “We’re getting inflation that’s so different from what the market expected, that the positions of market players are significantly out of place. The market can’t adjust to this information this quickly.”

If the Fed decides to hike by 100 basis points on July 27 — taking the fed-funds rate target to between 2.5% and 2.75% from a current level between 1.5% and 1.75% — “there will be a lot of losing positions and people on the wrong side of that trade,” he said. On the other hand, a 75 basis point hike “would disappoint” on the fear that the Fed is not serious about inflation.

All three major U.S. stock indexes are nursing year-to-date, double-digit losses as inflation moves higher. On Friday, Dow industrials
DJIA,
+2.15%,
S&P 500
SPX,
+1.92%
and Nasdaq Composite
COMP,
+1.79%
posted weekly losses of 0.2%, 0.9% and 1.6%, respectively, though they each finished sharply higher for the day.

For the past month, bond investors have swung back and forth between selling Treasurys in anticipation of higher rates and buying them on recession fears. Ten- and 30-year Treasury yields have each dropped three of the past four weeks amid renewed interest in the safety of government debt.

Long-dated Treasurys are one part of the financial market where there’s been “arguably less financial dislocation,” said economist Chris Low, Vogel’s New-York based colleague at FHN Financial, even though a deeply inverted Treasury curve supports the notion of a worsening economic outlook and markets may be stuck in a turbulent environment that lasts as long as the 2007-2009 financial crisis and recession.

Investors concerned about the direction of equity markets, while looking to avoid or trim back on cash and/or bond allocations, “can still participate in the upside potential of equity market returns and cut out a predefined amount of downside risk through options strategies,” said Johan Grahn, vice president and head of ETF strategy at Allianz Investment Management in Minneapolis, which oversees $19.5 billion. “They can do this on their own, or invest in ETFs that do it for them.”

Meanwhile, one of the defensive plays that bond investors can make is what David Petrosinelli, a senior trader at InspereX in New York, describes as “barbelling,” or owning securitized and government debt in the shorter and longer parts of the Treasury curve — a “tried-and-true strategy in a rising rate environment,” he told MarketWatch.

Next week’s economic calendar is relatively light as Fed policy makers head into a blackout period ahead of their next meeting.

Monday brings the NAHB home builders’ index for July, followed by June data on building permits and housing starts on Tuesday.

The next day, a report on June existing home sales is set to be released. Thursday’s data is made up of weekly jobless claims, the Philadelphia Fed’s July manufacturing index, and leading economic indicators for June. And on Friday, S&P Global’s U.S. manufacturing and services purchasing managers’ indexes are released.