Inflation may surprise to the upside and markets are overpricing the potential for the Fed to pull back on rate hikes, Deutsche Bank says

• There's potential for inflation to surprise to the upside, according to Deutsche Bank.
• In a note, the bank pointed to accelerating inflationary pressures in the November jobs report.

Stocks rallied last week on the hopes that the central bank will soon pull back from its hawkish policy, but the recent jobs report means there's still potential for inflation to surprise to the upside and for the Federal Reserve to stay aggressive, according to Deutsche Bank analyst Henry Allen.

"Labour market data offered a reminder that there are still plenty of reasons why inflation will surprise on the upside, not just the downside," Allen said in a note on Monday, referring to the newly released November jobs report.

Payrolls increased by an unexpected 263,000, while unemployment remained steady at 3.7%. Those are signs the labor market is hot and the economy is still expanding, even as the Fed has raised interest rates by nearly 400-basis-points so far this year.

The report also contained evidence that some inflationary pressures were still accelerating. Wage growth grew at its fastest rate since January, and the rate of workers quitting was still above pre-pandemic levels. The number of job vacancies for every unemployed person also fell modestly from 1.7 to 1.2 in November. That shows demand is still strong for workers and that there's still some upward pressure on wage growth, a key inflation input that the Fed has been watching.

Fed Chair Powell said in a speech last week that central bank policy would depend on the "future evolution of core inflation," Allen noted. That suggests the recent jobs data could bring a more hawkish bent to Fed policy going forward, potentially delaying the pause or pivot from aggressive rate hikes that investors have been hoping for.

Fed fund futures are currently pricing in a 50-basis-point rate hike from the Fed in December, a softer policy move compared to the stream of 75-basis-point hikes in recent months. Powell cemented those expectations by signaling the central bank would downshift in its tightening last week, sparking a brief surge in stocks. But markets were already pricing in that downshift, Allen noted, suggesting that Powell's speech caused investors to overreact to the comments.

"Perhaps investors were fearful of even more hawkishness, but was that really enough to drive the second-biggest daily gain in the last two years? The fact that the two biggest daily gains have both in the last month suggests that something else is going on, with investors desperate not to get left behind the curve when the rebound does arrive," Allen said. "Markets are still pricing in a more dovish hiking cycle than the Fed have themselves stated they will do."