Are the markets close to the inflation tipping point? It’s a matter of trust

This question has become very relevant in the wake of readings showing higher levels of inflation and an expansion in price pressures. October CPI inflation hit 31-year high 6.2% and 4.6% excluding food and energy, and the Federal Reserve raised its estimate for core inflation this year to 3.7% from 3.0%.

The financial market response has so far been muted: 10-year Treasury yields are down below 1.5% while the stock market is just below record highs. The main reason is that many investors agree with the Fed’s assessment that the recent rise in COVID-19 cases and emergence The Omicron variable poses downside risks to the economy and increases inflation uncertainty.

However, many prominent economists believe that high inflation has increased the risks of an oversold in the stock market. In a recent interview, Kenneth Rogoff of Harvard University said, “I think we’re on the knife edge” of where inflation is heading, calling the recent readings “eye-opening.” and chives Jeremy Siegel From Wharton noted that the stock market is “another bad inflation report” far from correcting if it causes the Federal Reserve to change its policy stance.

So, what indicates that inflation may be approaching the point of no return in the markets?

James McIntosh of the Wall Street Journal noted that markets were closed in May when inflation broke through The “magic number” by 4%. He noted that since the creation of the S&P 500 in 1957, US inflation as measured by CPI has risen above this level in nine cases, and US stocks have fallen in eight of them three months later.

The pattern is that when inflation is low – say 2% -3% – higher bond yields are associated with strong growth and a bullish stock market, and the correlations between stock prices and bond yields are positive. However, when inflation exceeds 4%, investors focus on the risks that monetary tightening will weaken the economy. One indication earlier this year was that the correlations between stock prices and bond yields turned negative, although they have since reverted to being slightly positive.

If one uses history as a guide, it is important to differentiate the periods in which inflation was transient from those in which it persisted. Examples of the former are 1984 and the mid-2000s when stocks quickly reversed losses as inflation eased.

The worst period for stock returns in real terms was in the early 1970s to the early 1980s when inflation persisted and reached double digits during the first two oil shocks. Investors eventually lost faith in the Federal Reserve, bond yields rose to record levels while the US dollar fell to record lows against the major currencies.

Inflation was curbed during Paul Volcker’s tenure as Chairman of the Federal Reserve. but, Investors tested the Fed’s resolve when Alan Greenspan succeeded Volcker, He was forced to raise interest rates which contributed to the stock market crash of October 1987. The Federal Reserve finally succeeded in taming inflation during the 1990s, and it remained in control until this year.

In my opinion, the closest analogy to the current situation is the late 1960s. Inflation was 5% at the time, but investors were slow to respond because it had been low – averaging 1%-2% per year – for more than a decade. As a result, investors ignored the initial rally and the stock market rallied for 6 months after inflation fell by 4%.

The main difference today is that inflation has picked up due to supply chain disruptions linked to the COVID-19 pandemic, which has complicated the picture. While investors are not alarmed so far, there are indications that the consumer Inflation expectations are rising. Unit labor costs have also increased in response to job vacancies and smoking cessation rates. And while wage pressures have been greater for low-paying jobs, they may spread to larger firms. For example, file Strike settlement for John Deere workers Give employees 10% pay bumps, $8,500 bonuses, and increased retirement benefits.

So, what could make investors change their minds?

My opinion is that there are two possibilities that both depend on how the Fed responds to inflation. One is that concerns about the coronavirus pandemic could push the Federal Reserve to delay raising interest rates until next year even if inflation readings remain well above its average annual target of 2%. If this is the case, investors may lose faith in US monetary policy at some point, and bond yields will rise while the US dollar weakens against major currencies. Such an outcome, in turn, is likely to lead to an intense sell-off in the stock market.

Alternatively, the Fed may realize that it is in danger of losing investor confidence and announce that it is ready to raise interest rates sooner than it currently indicates. If so, the Treasury yield curve could flatten as short-term interest rates rise while long-term yields decline. The stock market is likely to see a short-term correction, but it may recover if inflationary pressures ease and economic and corporate earnings continue to expand at a satisfactory pace.

The choice the Fed faces, in short, is whether it should deal with inflation that recedes on its own and take the risk of making mistakes, or be proactive in avoiding inflation and accepting near-term pain for long-term gains. Ultimately, how markets respond boils down to whether the Fed can maintain investor confidence.

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