Last night and this morning, the news that the overall inflation rate in the United States for June reached 9.1%, soaring to its highest level since 1981, did not detonate the financial markets like a bomb. On the contrary, the stock market's reaction to this news was relatively mild, and there was no panic.

The Nasdaq index briefly fell after the data was released, but soon turned upward. The Australian stock ASX200 index also opened slightly lower today, then turned positive, closing at 6,650.60 points, up 0.44%.

However, how long can investors' optimism last?

A few months ago, the consensus was that the overall inflation rate in the United States would peak around 8.5%. As a result, whether it is the overall inflation rate (which economists previously predicted to be 8.8%), the core inflation rate of 5.9% (expected to be 5.7%), or the magnitude of price increases, the actual data is obviously worse than expected.

Undoubtedly, high inflation has impacted people's daily lives, but for investors, in addition to a significant increase in gasoline expenses, they must also face two key questions:

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First, how severe might a recession in the U.S. economy be?

Second, when will the market fully digest a possible recession?

A direct one percentage point interest rate hike? Possible!

Looking at the inflation data from the United States this time, energy accounts for a significant proportion, with gasoline prices rising 11% year-on-year in June! The current decline in oil prices has not yet been reflected in this data.Apparel prices rose by 0.8% within a month. The prices of new and used cars also saw a surge. Auto insurance prices increased by 1.9% for the month, and by 13% year-over-year. Within the broad category of food, the prices of beer, baby food, chicken, frozen fruits, and vegetables all reached the highest inflation rate in the history of inflation statistics.

The most concerning issue is the rise in rent (which is also the case in Australian capital cities). Data shows that rent increased by 0.6% for the month, and by 5.8% year-over-year, reaching the highest level since 1986. Stephen Stanley, Chief Economist at Amherst Pierpont Securities, stated that the soaring housing prices in the United States are finally reflected in the Consumer Price Index (CPI) data. The fact will prove that this increase is still ongoing.

He said, "Even if housing prices stabilize in the coming months, CPI housing costs may also take more than half a year to gradually decrease.

The record-breaking inflation data leaves Federal Reserve Chairman Jerome Powell with no choice but to more actively combat inflation and raise interest rates. He previously stated that the Federal Reserve needs to see evidence of a month-over-month decrease in inflation before slowing the pace of interest rate hikes. Although the decline in gasoline and commodity prices will be transmitted to consumer prices in the coming months, inflation may only moderately decrease.

The 9.1% inflation data almost predicts that the Federal Reserve will raise interest rates by at least 0.75 percentage points at this month's interest rate meeting, and the bond market's "bet" on a direct 1 percentage point rate hike has significantly increased.

This alone indicates how worrying the inflation situation has become. Until March of this year, the market still considered a 50 basis point interest rate hike by the Federal Reserve to be a super aggressive approach. Then, in June, Powell announced an increase of 75 basis points, far exceeding market expectations.

Tom Porcelli, Chief U.S. Economist at RBC Capital Markets, said that the Federal Reserve is very likely to raise interest rates significantly again, just like last time, due to the new round of inflation figures.

Is the market still too "optimistic"?

As the Federal Reserve becomes more aggressive, investors increasingly need to face a question: When will the United States fall into a recession?

It needs to be clarified that there is still a great debate about whether the United States will really fall into a recession. Previously, even economists who thought a recession would occur, also scheduled the recession for next year. Before the release of this CPI data, many economists and strategists believed that there was a 50% chance for the United States to avoid a recession.However, at the same time as the inflation data was released, Bank of America changed its forecast for the U.S. economy, predicting a mild recession due to the deterioration of service sector spending and weak credit and debit card data. There are also other institutions that believe the U.S. economy will enter a recession this year.

In Porcelli's view, the likelihood of avoiding a recession has definitely decreased now. More and more signs indicate that the U.S. economy is slowing down, and the Federal Reserve seems increasingly likely to accept a recession (hopefully a mild one) rather than persistent high inflation. Because the risks brought by this inflation are more deeply rooted.

The financial market's reaction to the CPI data shows that investors were not particularly surprised by the data; the stock market only fell moderately, and commodity prices fell but recovered (oil prices actually rose). Although the trend of two-year and ten-year U.S. Treasury bonds in the bond market further reversed, indicating that interest rates will rise significantly in the short term.

With the U.S. stock market falling by 21% this year and commodity prices falling sharply last month (the CBR commodity index fell by 16% since June 9), the financial market seems to have digested the impact of a mild recession in the U.S. economy. In fact, the optimistic idea that "the Federal Reserve will end interest rate hikes faster, control inflation, and then prepare to cut interest rates to support the weak economy (and stock prices)" has been accepted by more investors in recent weeks.

However, despite the risk of the U.S. economy falling into a sharp decline, many corporate profit expectations have not been adjusted as expected. The profit margins of listed companies are still close to historical highs.

The recession may have been reflected in the stock market valuation, but has the stock market underestimated the accompanying slowdown in profits?

U.S. household consumption accounts for about 70% of GDP, and this important economic component has now been hit. According to the latest forecast of the Federal Reserve Bank of Atlanta, the decline in purchasing power will push the U.S. economy into a recession ahead of schedule, and they estimate that the U.S. economy shrank by 2.1% in the second quarter of 2022.

Does Australia have a chance to avoid a recession?

The bigger question is how severe the U.S. economic recession will ultimately be and how it will drag down the economies of other countries around the world.

The bond market's pricing of the federal funds rate is still around 3.65% (higher than the 3.45% before the inflation data was released), but most economists believe that the Federal Reserve will be forced to raise interest rates to at least 4%, or even higher.The alarming aspect of this data is that it indicates inflation may be more entrenched than the market might think. Not only the Federal Reserve, but central banks around the world may need to raise interest rates more significantly and slow down economic growth to control inflation, including Australia.

The latest data released today (July 14th) by the Australian Bureau of Statistics shows that the unemployment rate across Australia has dropped to 3.5%, the lowest level since August 1974. The number of employed people has also increased for the eighth time.

This reflects an increasing participation of the labor force in the market. However, there seems to be no sign of alleviation in the labor shortage issue, which means that the cost of labor will not decrease the pressure on inflation.

It can be expected that the Reserve Bank of Australia (RBA) will continue to maintain a "hawkish" stance and raise interest rates. But will it follow the footsteps of the Federal Reserve?

Looking at the intensity of the rate hike last month, the RBA is still maintaining its own pace. However, strong employment data may give the central bank a push. Nomura Securities wrote in a recent report to clients: "We now expect the RBA to raise interest rates by 75 basis points in August, with a risk of 100 basis points."

However, some of Australia's largest investors (such as the pension funds of construction unions) are betting that the RBA can control inflation next year. To this end, they have increased their bond holdings from slightly below 6% to about 10% over the past 3-6 months.

Historically, bond yields usually peak early in the tightening cycle. Once inflation begins to decline moderately over the next 18 months, bond prices will recover, which is why many funds are reallocating bonds.

They predict that although the RBA will continue to raise interest rates, it will not raise rates to a high of 3.5% by the middle of next year as the market "prices in." The current normalization of the RBA's monetary policy is "orderly," and it is still very likely to avoid Australia falling into a recession.

Of course, everything still depends on the situation of inflation control.

As International Monetary Fund (IMF) Managing Director Kristalina Georgieva said last week, "2022 will be very difficult - 2023 may even be more difficult, with the risk of recession increasing." She said that the global growth forecast to be released by the IMF later this month will be lower than the previous one.