Investors have digested the idea that inflation is currently exceeding previous expectations. Now the focus is on the Federal Reserve – and how quickly it will respond to rising prices.
There have been many reasons for concern. Measures of price inflation paid by consumers have consistently exceeded expectations in recent weeks. A year ago, prices were lowered by the pandemic, so they are rising rapidly as life in the United States returns to normal. Billions of dollars in government aid create demand, while supply chain problems drive up costs for businesses, forcing them to raise prices.
has been mostly flat since mid-April, a stretch that included a 4% decline.
Prices in the bond market indicate that investors expect inflation over the next five years to reach an annual rate of 2.62%, down from less than 2% at the start of the year. Still, the expected rate is down more than 2.7% on May 10.
“This fear of the inflationary shock has abated over the past week,” wrote Dennis DeBusschere, head of portfolio strategy research at Evercore.
Now, investors are watching the Fed to see how quickly it reacts to inflation. The Fed’s first move would likely be to reduce the amount of bonds it has purchased as part of its efforts to keep interest rates low and the economy running smoothly during the pandemic.
Less money entering the market would lower bond prices and increase bond yields, thus increasing the cost of borrowing for buyers and businesses. Higher yields also erode the present value of future cash flows, leading to lower stock valuations.
The minutes of the Fed’s April 28-29 policy meeting, released last week, even raised the possibility that members could start discussing reducing or reducing the asset purchase program when of the next meetings. “In the eyes of investors, the timing of the cut signal has been moved to July instead of August,” DeBusschere says.
And while phasing out would be the first step, the second could be to raise the benchmark interest rate, something that could come sooner than expected. The federal funds rate futures market now reflects a rate just below 0.25%, down from 0.2% a few weeks ago, Evercore data showed. The Fed’s current target range for the rate is between 0% and 0.25%.
The point is, investors now expect interest rates at all levels to rise as soon as possible. Don’t be surprised to see significant stock market volatility as the Fed story unfolds.
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