A tumultuous two weeks in markets culminated in a positive job report, but inflation concerns still threaten the near and long-term equity outlook.
Interest Rates and Inflation
The relationship between interest rates and inflation is an inverse one. The higher the interest rates, the lower the inflation, and vice versa. This is because when interest rates are high, people are less likely to spend money, since they can earn a higher return from investing it. When interest rates are low, people are more likely to spend money, since they can‘t earn as much from investing it. This eventually causes prices to rise, leading to inflation. The Federal Reserve attempts to manage inflation by manipulating these interest rates, namely the Federal Funds rate. The Fed funds rate is the interest rate that banks charge each other for overnight loans. It’s a good indicator of the overall state of the economy because it’s set by the Federal Reserve, and it affects other interest rates. When the Fed funds rate is high, it means that the Fed is trying to cool down the economy. When it’s low, it means that the Fed is trying to stimulate the economy. A rise in interest rates also affects stock prices, bond prices, and the value of the dollar. Stock prices are affected by inflation because companies have to increase their prices to cover the higher costs of doing business. Bond prices are affected because investors demand a higher return on bonds that are inflation–proof and the value of the dollar is affected because it becomes less valuable when prices rise. To temper inflation the Federal Reserve has a couple of options. One is to raise the short–term interest rate which would increase borrowing costs and slow down the economy. The second is to sell Treasury Securities, which would take money out of the market and could lead to a rise in interest rates. This is mostly what has been discussed over the past two weeks which has lead to massive intra-day market swings and investors exiting positions. The crypto markets have also been affected despite the relationship between crypto currencies and interest rates being less correlated than perhaps with other asset classes. When the economy slows then the Federal Reserve may also choose to purchase Treasury Securities, which would increase the money supply and stimulate the economy. When the economy gets hot–as we’ve seen for the past few years–the Federal Reserve will usually increase the short–term interest rates to cool it down. At present this is in response to rising inflation that has not been seen in over 30-years. The Federal Reserve will likely begin to reduce its balance sheet by not reinvesting all of the proceeds from maturing Treasury Securities and mortgage–backed securities. They buy these types of securities to stimulate the economy, so when they stop buying them, it will start to cool down. Investors can expect stocks to perform poorly when the Federal Reserve is selling securities because it means that the economy is doing well and they expect interest rates to rise, which would make it more expensive to borrow money.
What about the bond market?
This affects the bond markets as well. As bond prices rise, the yield falls The inverse relationship plays itself out as a higher price which means that investors are demanding a lower return in order to hold the bond. Conversely, as bond prices fall, the yield rises, since investors are now willing to accept a higher return in order to hold the bond. The yield on a bond is an important factor in determining its price. The higher the yield, the less attractive the bond is to investors, and vice versa. This is because a higher yield means that the investor will earn a higher return on their investment. The yield on a bond is also important in determining its credit rating. The higher the yield, the less likely it is that the bond will be able to repay its principal and interest payments. This can lead to a downgrade in the bond‘s credit rating, which will make it less attractive to investors. Bonds become significantly more attractive if equities perform poorly. All of this in spite of a positive jobs report, near-record employment and labor force participation the economy still looks relatively strong despite the increase in prices across wages and goods and services spectrum.
What next?
The Federal Reserve has not specified how many interest rate hikes they expect to implement over the coming months/years, but given current equity market volatility, it seems investors are beginning to price those hikes into the prices of their traded securities.
