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US CPI (Consumer Price Index) i.e. annual inflation has just been released and has come out at a 39-year high of 7%.This could be described as ‘red hot inflation’ and this sets the stage for interest rates hikes by the US Federal Reserve (Central Bank).

Higher interest rates are 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/decreases profitability.

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

So how much did stocks fall on this news?

How much did the US Dollar rally as the driving force for any currency in the short term is the level of its interest rates so if the latter are heading higher that will strengthen the currency?

The opposite happened: US stocks rose and the US Dollar weakened. This is against traditional economic theory where if inflation is rampant, interest rates go up and that is a negative influence on stock prices.

Why did the opposite happen?

It’s all about market positioning and expectations: The New Year started with the notion that inflation is much higher than the Fed anticipated a few months ago. This has caused the Fed to become much more ‘hawkish’. We saw that in the Central Bank FOMC meeting minutes released in early January and in a speech from FED Chairperson Jay Powell when he talked about “inflation is too high, we are going to get it back under control” and he referred to the Fed “shrinking its balance sheet” i.e. reducing its bond buying and therefore reducing its accommodative financial support to the financial system (when the Central Bank buys a bond off an investment bank, it owns the bond and supplies funds to the investment bank so increasing the money supply. The Central Bank’s assets and liabilities i.e. Balance Sheet increases. If the Balance Sheet is reduced by e.g. selling bonds back to investment banks, this has the reverse effect and decreases the money supply and therefore the financial support to financial markets).     

So, the markets started 2022 expecting not just a hike in interest rates (3 or 4 quarter point rises this year) but an end to Quantitative Easing and a reduction in Fed’s Balance Sheet. So, stock markets fell in early January. The US NASDAQ (which is very sensitive to interest rate rises) fell over 10%. Interest rates / Bond Yields rose sharply with the yield on the 10-year US Government Bond going from 1.50% Yield-to-Maturity at the end of the year to 1.80% by January 10th.

So, the sharp rise in interest rates/bond yields and fall in stock prices took place before the release of the 7% annual inflation data. The 7% figure was in line with expectations and some investors feared the number was going to be higher. So, although it was the highest inflation figure since 1991 the markets were positioned for even worse news. When the number came in no worse than expectations this was viewed almost as good news and, on this basis, stocks rose, bond yields fell a little and the dollar weakened with the modest fall in interest rates/bond yields. So, the inflation shock never materialised. This was viewed with relief so stock prices rose albeit modestly on the news.

So, you need to be aware how the markets are positioned and context is king to interpret market news.