Markets Flat As They Weigh Up The Impact Of Inflation

The Dow, S&P 500, and other major global indices were flat during early February, due to uncertainty regarding the impact of inflation and the on-off rhetoric of the Ukraine issue. However, while indices are holding their ground, they are also seeing tremendous intra-day volatility as investors try to calculate what higher inflation will mean later in the year.

Case For Bonds

Typically, when inflation picks up, central banks respond by raising the base rate. It becomes more expensive for banks and other financial institutions to borrow, putting the rate of interest up across the entire economy.

As rates rise, the opportunity cost of holding bonds at lower rates also rises. This then forces bond sellers to increase their rates. When that happens, investors move out of stocks to bonds to take advantage of lower-risk returns.

….But is this likely?

Right now investors are sceptical that central banks have the necessary wiggle room to enact such a policy.

While raising interest rates is the conventional policy remedy for inflation, it does not seem feasible from a macroeconomic perspective.

Any sustained rise in interest rates is likely to result in a house market crisis similar to the one seen in 2007-2009. Households will not be able to make payments on their mortgages if rates rise by too much (coupled with the rising cost of living).

What Should Traders Do?

Given these circumstances, traders need to think carefully about which institution they believe has more power: the democratic government or central banks.

In most developed nations, including the US and UK, central banks must control inflation while balancing employment.

Right now, employment is roaring away. Most companies can’t acquire the talent they need. Inflation is high and edging higher as well, so central banks have massive incentives to raise rates.

However, doing so will generate tremendous political pressure. Therefore, governments may lean heavily on central bank governors to be dovish, preventing hardship for citizens. In which case, markets will likely rise as bonds become less attractive and equities become a safe hedge against inflation.

Traders, therefore, need to decide which political situation is more likely. They then need to use this insight to short the market they think is headed for disaster: either stocks or bonds.