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The biggest question for markets? As the global economy recovers, after tremendous levels of Central Bank stimulus, which has pumped extreme amounts of money into the economy is, is inflation returning?

Let’s be clear, inflation is bad news for financial markets – it erodes the real value of assets and it normally leads to higher interest rates. Higher interest rates are bad for both bond and stock markets:

Bonds – if interest rates shift from 1% to 2% then current bond prices fall to accommodate that interest rate rise so that a bond yielding 1% now yields 2% (remember bond prices and yields have an inverse relationship – as yields/interest rates rise, bond prices fall).  

Higher interest rates are also bad for stocks since

-higher interest rates make investing in bonds relatively more attractive versus stocks

-higher interest rates/bond yields raise the cost of corporate borrowing e.g. If Coca Cola has to issue a 10-year bond at 3% not 2% that directly increases their borrowing costs.

-higher interest rates result in lower present day stock valuations as analysts discount future earnings using higher interest rates

Where is inflation now?

Central Banks normally target 2% annual inflation (not zero as the risk of missing the target and having a deflationary environment where consumer debt increases in real terms is too dangerous a target).

In the US, inflation has jumped over the last few months to an annual rate of over 5%.

In Europe, inflation is also above target at 3%.

So, the markets are asking?

  1.  Will the US Federal Reserve become less accommodative and taper (reduce) its $120 Billion monthly bond purchase programme (Note: When a Central Bank buys a bond from a bank, it gives the bank money for the security, so increasing the money supply)
  2. Will the ECB (European Central Bank) slowdown its EUR 1.85 trillion pandemic emergency bond purchase programme)?  
  3. Will both Central Banks also raise interest rates to combat the inflationary threat?

But it is not as simple as this? Both Central Banks have made noises over the last few months that they think the current uptick in inflation is temporary as the data is comparing prices today with pretty much the economic lows of the Coronavirus crisis 12 months ago. But no doubt, inflation is rising in many countries as the world economy rebounds from the impact of the pandemic, increasing pressure on central banks to start winding down back the monetary stimulus they launched last year. Indeed, Jay Powell, Chairman of the US Federal Reserve said last week that it would start scaling back its asset purchases this year but also spoke of the dangers of reducing the Fed’s $120 BN of monthly purchases of debt too rapidly – the markets liked the latter ‘dovish’ comments.

But ‘the proof of the pudding is in the eating’ i.e., everything is reflected in current bond yields and equity prices. Financial markets are relaxed about the inflationary threat at the moment.

Indeed, financial markets are watching inflation data very carefully. There is no doubt inflation is rising – but is it a temporary blip? Financial markets will also hang on every word uttered by the Fed and the ECB to understand their thinking and the impact on policy and therefore financial market asset values.

Equities – looking at the main US equity markets of the S&P 500, Dow Jones Industrial Index (DJII) and the NASDAQ, are at or close to all-time highs!

Bonds – the US 10-year Government Bond is the key security to follow. It is currently trading at 1.30 yield-to-maturity (annual rate of return) which is down from a high-yield of circa 1.78% 3 or 4 months ago when inflationary fears where at the greatest. If markets truly thought inflation was going to take off, the figure would be closer to 2%.   

But only time will tell if the relaxed nature of financial markets, which has seen the S&P 500 index enjoy its seventh consecutive month of gains including 3% in August, are right.

Commodities: GOLD is trading just below $1,800 per ounce, well below its peak of $2,050 reached in the summer of 2020. Gold performs best in an inflationary environment since it holds its real value i.e., a bar of gold is worth a bar of gold whatever inflation does.

OIL: Brent oil is trading $70 per barrel. Not as high as recent peaks but well above the Covid-stricken lows of last year of $20 pb. Generally, most commodities, from zinc to nickel to timber to aluminium are at multi-year highs as the global economy recovers.

Keep following the US 10-year bond yield – it tells you everything you need to know about financial market sentiment and the current market thinking on “Is inflation returning?”