Rising Inflation Spooks Markets, but Should It?

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.

"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.