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Rising Inflation Spooks Markets, but Should It?

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What You Need to Know

  • “Inflation remains the biggest risk to financial markets,” said Daniel Shaykevich, senior portfolio manager at Vanguard.
  • The Federal Reserve says rising inflation is
  • The April CPI report showed prices jumping 4.2% vs. April 2020, the biggest rise in over a dozen years.

The 4.2% jump in April consumer prices, which was the biggest year-over-year increase in more than 12 years, spooked stock and bond markets alike on Wednesday.

Both the Dow Jones Industrial Average and the S&P 500 fell about 2%, while the Nasdaq retreated 2.7%, and the 10-year Treasury yield reached 1.7%, its highest level since late March.

“Inflation remains the biggest risk to financial markets,” said Daniel Shaykevich, senior portfolio manager at Vanguard, who spoke on a webinar about the post-COVID bond market. “It is the only constraint on what central banks can do to support the economy.”

He noted that if the major market risk is coming from inflation, like today, bonds and stocks can move in the same direction, which was the case.

The Market vs. the Fed

Whether that risk will continue and drive stock and bond markets lower is uncertain. The Federal Reserve has repeatedly said inflation will rise largely because of the “base effects” of comparing today’s prices to those at the same time a year ago when the economy was mired in a deep downturn due the spreading coronavirus pandemic.

The increase will be “transitory,” according to Fed Chairman Jerome Powell and other central bank officials. On Wednesday Fed Vice Chairman Richard Clarida repeated the refrain, though he said he was surprised by the 4.2% print, which was above what he and others had been expecting. Clarida noted that the Fed would be monitoring long-term inflation expectations “very closely.”

Rick Rieder, BlackRock’s chief investment officer of global fixed income and head of the BlackRock global allocation investment team, isn’t as assured as the Fed about the temporary nature of rising prices.

“While the Fed may continue to describe this inflation spike as ‘transitory,’ should we witness a series of upside surprises to inflation, like today’s, then markets might begin to challenge the Fed’s narrative,” Rieder wrote in his commentary on the April inflation report.

Leading Wednesday’s surge in consumer prices was a 10% jump in used car prices and a 50% increase in energy prices from the previous April. The core CPI, which excludes food and energy prices, rose 3%, the biggest jump since 1981.

“One thing can’t be any clearer here, the parts of the economy that are coming back don’t have enough inventory of product to supply the demand at current prices and the data making that case is overwhelming,” Rieder wrote. ‘While some of these price gains are transitory and will clearly be brought into balance in terms of supply/demand, other prices are moving much higher in some areas as the demand grossly eclipses the available supply.”

He noted the rising prices in semiconductors due to supply shortages and the rising prices in airline fares and lodging, reflecting growing demand as the economy recovers.

Inflation Expectations

Inflation expectations are rising along with prices as evidenced by the breakeven levels for Treasury Inflation Protected Securities (TIPS). The breakeven, which measures the difference between the yields of Treasuries and TIPS of similar maturities, widened to 2.54% for 10-year securities and 2.71% for five-year securities on Wednesday.

The fact that five-year breakeven is higher than the 10-year one is unusual, said Anne Mathias, head of global rates and FX strategies at Vanguard, who joined Shaykevich on the webinar Wednesday. She expects the inflation will normalize and the Fed will continue to refrain from raising short-term rates even if long-term rates continue to rise.

The Fed has adopted a new framework to let inflation top its 2% target rate for a time so that inflation averages 2% over time. That “average inflation targeting represents a major break in the Fed’s approach to managing the economy,” said Mathias. “The Fed wants our expectations for inflation in the future to rise … wants you to think we’re at the beginning of a huge boom that will last a long time,” presumably so consumers and businesses spend more and boost growth.

Mathias is forecasting that the 10-year Treasury will trade in a range between 1.65% and 2.15% over the next three to six months. If rates continue to rise, she said, the Fed could revive its Operation Twist strategy,  purchasing longer dated securities in the market while selling short-term securities from its balance sheet, which has worked before.

“Inflation might surprise on the upside,” said Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. “Not 1970s-style inflation, but more than most investors or investment managers have experienced over the past 20-25 years.”

Jones is watching whether “wage growth becomes stronger for lower-skilled or less educated workers and various supports for families such as child care, etc., emerge from the new [federal] legislation” increase aggregate demand. “It hasn’t happened in decades, but this is the closest … to a growing consensus that I’ve seen in decades.”

Her colleague Liz Ann Sonders, chief investment strategist at Schwab, said ongoing inflation concerns have increased the importance for stock investors to focus on quality and “value” and not limit their universe to only sectors that dominate the value indexes.