Market Explainer: Rising Interest Rates and Inflation

Federal Reserve Chairman Jerome Powell demonstrated his determination to return the U.S. economy to full strength, stating that the central bank will not begin to tighten low-rate policies until it sees significantly more improvement. The stock market was quick to react. The Dow Jones average rose 1.3% and crossed 32000 for the first time. The S&P 500 rose 1.1%, The Nasdaq Composite rose 1%, and 10-year Treasury yields rose 1.43%. Investors recently sold technology stocks, since tech companies’ future profits are worth less if higher interest rates brought by an improving economy make Treasury yields more appealing. These quickly rebounded after the announcement.


This action represents a major shift in how the Fed sets interest rates by dropping its longstanding practice of pre-emptively lifting them to counter higher inflation. The fear used to be that when joblessness falls below the natural rate of unemployment, prices will rise. In order to contain inflation, the central bank hikes interest rates since higher rates increase the cost of borrowing for both consumers and firms—discouraging them from spending and investment. While this can keep price levels in check, there is a risk of causing a recession. However, the Fed is currently prioritizing the restoration of the labour market. Although the reported unemployment rate has dropped to 6.3%, when considering the more than 4 million workers who have been forced out of the labour force, as well as misclassification, the actual unemployment rate is close to 10%.


The most immediate problem is rising inflation expectations. This can be seen in Treasury markets by looking at the difference between the yields on ordinary Treasuries and the yields on Treasury Inflation-Protect Security (TIPS). This difference is called the break-even-rate. The difference between five-year Treasury and TIPS yields shows break-even inflation expectations have risen to nearly 2.4%, the highest since May 2011. More surprisingly, shorter-term break-even rates are higher than longer-term rates—an extremely rare situation known as an inversion of the break-even rates. This forecasts a spike in inflation that will later fade away.


There seem to be three possible explanations for the abnormality. The first possibility is that the 1.9 trillion USD COVID-19 relief package will bring only short-term benefits and only short-lived inflation. Another view is that investors expect that the Fed, contrary to promises, will react swiftly to cap inflation and keep it close to its 2% target. This may be the first test of the Fed’s commitment to the new average inflation target regime. The third view is that the market is simply mistaken, under-predicting the effect of government stimulus spending.


If these inflation expectations do lead to higher interest rates in the future, this could be painful for equity markets as asset prices tend to move inversely to interest rates. Portfolios with more exposure to equities tend to suffer reduced valuations as Treasuries offer a lower risk source of income. Moreover, growth stock valuations, including Big Tech companies which have almost single-handedly led the bullish market pre and even during the pandemic despite often never turning a profit, are dependent on future cash flows. Higher interest rates erode these potential cashflows as the cost to borrow, and so overall cost of capital increases, leaving less promising balance sheets, creating a disconnect between them and the very large valuations of these companies.


However, as of yet, there is little reason to worry about rapidly rising inflation. The economy is still far from operating at full capacity; only once it returns to its usual functioning will inflation pressures start to become problematic. The United States is still about 10 million jobs short of full employment and this gap will take time to close. In the upcoming recovery cycle, increasing demand for services will meet the constrained supply. Inflation rates will go up, but Fed officials have signalled that they will not react to this transitory rise. As the economy then gradually moves back to full employment in a few years’ time, inflation will move towards the 2% target and keep climbing. At this point, the Fed will likely start increasing short-term interest rates. The process may have to be carried out quickly as rates have to be a lot higher than the current near-zero level to be restrictive. After the recovery, the US may be left with the highest interest rates in recent years, causing concern among equity investors. Fortunately, the Fed will have more tools to fight the next recession


By Matthew Xiao

Sector Head: Jackson Philips







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