If somebody had said with certainty at the start of the year that US inflation would hit 6.2% in October, would anybody have predicted a 10-year Treasury bond rate of just 1.64% or that the S&P 500 index would go on to hit record highs? Would anyone have gambled on there being no clear pattern in the nominal bond yield, fluctuating as it has since spring within a relatively small range of between 1.20% and 1.75% in the US and between -0.50% and -0.10% in Germany? Could the bond and stock markets have become immune to inflationary risk, or is this an illusion?

Several factors might explain current market behaviour in the face of higher inflation. Firstly, the high inflation is considered transitory. This is the belief of the central banks and it is shared by professional forecasters, who are collectively predicting that inflation will fall next year. The findings of the European Central Bank’s survey of monetary analysts and the US Federal Reserve‘s survey of market operators are both along the same lines.

We know why inflation falls back again: baseline effects, particular occasional factors that drive inflation such as the price of second-hand vehicles, the prospect of a gradual reduction in bottlenecks affecting inputs, and so on. Secondly, in recent times, break-even inflation rates have risen sharply in the euro zone and in the US, where they are at 2.7% – almost a record. A trend towards higher long-term rates – at actual rates which remain unchanged – would necessitate a further rise in break-even inflation rates, and therefore a firm belief that high inflation should last for some time, which seems unlikely. Thirdly, the markets believe that the accumulated monetary tightening in this cycle will be quite limited. And this outlook prevents real rates from rising significantly. It may convey a feeling that the economy will be fairly sensitive to rises in key rates, however small they may be in comparison with the previous cycles of tightening. The fourth factor is closely linked to the third, with bond markets which reflect the statistical distribution of various economic scenarios. Thus, the short part of the yield curve illustrates quicker tightening in the US, UK and in the euro zone than the message from the various central banks.

Investors therefore feel that in the short term, inflation could spring another rise. On this subject, monetary policy expectations in the UK are very revealing, with the market counting on several rate rises followed by a series of decisions to relax rates from the end of 2023. So, with some cynicism, market operators are waiting for a monetary policy error from the Bank of England. On the other hand, the long part may ‘price in’ the slowdown in growth that would result from a period of monetary tightening. A fifth factor is that the markets are speculating on diversification across the various asset classes. A less accommodating policy on the part of the central banks runs the risk of a structural increase in the volatility of shares, listed real estate and corporate bonds, etc. In addition, prospects for company cashflow growth would be liable to be revised downwards. This combination of factors increases the appeal of government bonds, and the prices of these should rise if risky assets perform disappointingly.

A sixth aspect specifically concerns those equity markets which could benefit from a rise in inflation, for two reasons: firstly, this rise reflects very dynamic demand, which means significant growth in turnover and, by extension, profits; secondly, it might also reflect a greater capacity on the part of companies to increase their sale price. Therefore, elasticity of demand relative to prices is likely to be lower when demand is high – and all the more so when delivery times are long.

Finally, monetary policy credibility is crucial. It allows inflation forecasts to be pegged closely to central banks’ targets. Moreover, it guarantees that high inflation will be temporary. If it should remain high for too long, the central banks would take the necessary measures. This is precisely the message from the Federal Reserve and the ECB. This type of shift in monetary policy direction would produce an effect on the short part of the yield curve, which would see a rise in yields, while the long part might experience the opposite as a result of the market anticipating the negative effect on economic growth of a period of monetary tightening. This same factor could also cause a fall in stock market prices. Therefore, to what extent the markets are immune to inflationary risk will essentially depend on how the fall in inflation comes about. To sum up, the risk that this immunity is merely an illusion is very real indeed.

Reproduced with the kind authorisation of L’AGEFI Hebdo (article published on Nov.25, 2021)