Will Inflation Rise? And What It Means for Stocks and Bonds

By Roman Chuyan, CFA In this article, I review the recent rise in yields and in inflation expectations, and what it might mean to bond and equity investors. Treasury yields have jumped sharply so far in 2021 on concerns about rising inflation.

Source: Will Inflation Rise? And What It Means for Stocks and Bonds

The 10-year yield jumped by around 60 basis points to 1.55%, and the 5-year increased by over 45 bps to 0.83% (see chart below). Are inflation concerns justified?

Treasury Rates, 10 Years

Source: Ycharts

In fact, the 1-year inflation expectation has surged to 3.3%, as the following 30-year chart shows. Actual inflation has not yet fully recovered, however, after plunging during the early-2020 lockdown crisis. While total inflation rose to 1.7% in February (the purple line on the chart below) due to rising energy prices, core inflation, excluding food and energy, dropped to 1.3% in February from 1.6% in December. This 30-year chart also illustrates that inflation expectations overestimated actual inflation for about 10 years.

Inflation and Inflation Expectations, 30 Years

Source: Ycharts

Economists have split views on this (as always). Capital Economics thinks that “Biden’s proposed $1.9tn fiscal stimulus package would add to a growing list of reasons to brace for a possible upside inflation surprise,”[1] while TS Lombard remains adamant that “the consensus is wrong – no inflation this year… Short term inflation fears are extremely overdone.”[2]

Rising inflation and interest rates are of concern to bond investors. Bond prices, which move opposite to rates, would drop further if rates continue to rise. However, there isn’t yet evidence of inflation rising significantly (and core inflation is actually falling). We at Model Capital think that inflation might rise moderately later this year. However, the market might have already priced-in this possibility.

In addition, Fed officials have repeatedly indicated that they will keep the funding rate near zero until at least late-2022. The European Central Bank just announced that it would boost its bond buying to stem rate rise, and the Fed is expected to do the same at its meeting next week. While we think that it’s prudent to shorten duration this year, as a practical matter, we think that managers shouldn’t panic as the market might present a better opportunity to do so in the coming weeks.

[1] Source: Capital Economics report, Biden’s Fiscal Plans Add to US Inflation Risk, 3/2/2021.

[2] Source: TS Lombard special report, The Consensus Is Wrong – No Inflation This Year, 3/2/2021.

Equity Market Outlook

A separate question is what effect, if any, rising rates would have on the stock market. Market volatility has already increased in the past week, and I think stock investors are right to be concerned. Recall that stocks began to drop the moment the 10-year Treasury rate rose above 3.25% in October of 2018 (see chart below). The concern was, and remains, that higher rates would burden the financial system due to enormous debt. It’s my view that this time, the “too-high” rate level will be lower because there’s even more debt and we’ve been conditioned by zero rates in the past year. That critical level may well be around 1.5%-1.6% on the 10-year Treasury.

Treasury Rate & The S&P 500, 3 Years

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Source: Ycharts. Investors cannot invest directly in the S&P 500 index.

The above chart also reminds us that the S&P 500 plunged by almost 20% by Christmas of 2018, despite rates pulling back. So, rising yields initially triggered a stock market downturn, and it then proceeded due to high market valuation.

We’re in a similar situation today. As I wrote in this recent article, the 6-month return forecast for the S&P 500 by Model Capital’s fundamentals-based Equity Model remains significantly negative, due primarily to extremely high market valuation – the model calculates that the S&P 500 is overvalued by 17% over a 6-month horizon. So, once a correction begins, it could be significant.

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