The stock market is a favorite topic of cocktail party conversation these days, and for good reason: global stocks finished 58% higher on May 31st versus the end of the first quarter of 2020. Granted, that astronomical 14-month return began during the early days of the coronavirus pandemic when stock prices were extremely depressed. But, regardless of the starting point, a gain of that magnitude always draws interest from casual observers as well as investment professionals and stay-at-home day traders.
While this bounce in the stock market was happening, a much less exciting but potentially more impactful surge somehow eluded public scrutiny: intermediate and long-term interest rates, which had plummeted in the early days of the pandemic, began to rise. The US ten-year bond, which had yielded 0.62% in March 2020, rose to a peak of 1.75% earlier this year. Its movement has led to some hand-wringing among politicians and market commentators, and their concern centers on one thing: inflation.
Rising bond yields are often interpreted as a sign that inflation will be higher in the future, because bond investors demand a higher interest rate if they expect inflation to increase. Many of us remember the 1970s and ‘80s and the havoc that double-digit inflation rates caused for the economy. Consumers as well as policy makers have a vested interest in avoiding a return to such an environment.
So why would the bond market be signaling an increase in inflation? The answer is “fiscal stimulus,” which is just a fancy term used to describe all those checks that the government has been mailing out since the beginning of the pandemic. So far, the government has approved $5 trillion in stimulus packages to help offset the pandemic’s economic impact, and this does not include President Biden’s proposed infrastructure bill, which could add another $2 trillion to the total.
Clearly these measures have done, and will continue to do, a great deal to bolster the economy during a very difficult period. But as the economy continues to reopen, those trillions of dollars will be chasing all sorts of goods and services that are in limited supply, which can lead to higher prices across the board. In other words, economic stimulus does stimulate the economy – sometimes too much.
What Me Worry
One possible reason for the sanguine attitude of the bond market toward inflation is the market’s recognition that a tax increase will likely be necessary to pay for all this recent government largesse. Tax increases tend to act as “anti-stimuli” for the economy, and an increase in tax rates could help tamp down inflation in the coming years. So, instead of worrying about inflation, you may want to consider worrying about the cost of the stimulus packages and how much of it you, your children, or your grandchildren will be asked to cover.
Our conclusion: a significantly higher level of future inflation is possible, but it is not guaranteed. Keep in mind that the same inflation concerns arose after the global financial crisis of 2008. At that time, the US government undertook unprecedented fiscal and monetary measures to stimulate the faltering economy. The measures taken stirred predictions of hyperinflation, but price increases remained below historic norms in the subsequent years. It may be different this time, but the consensus opinion of the major players in the bond market indicates that we will likely see only a modest increase in inflation and, if this changes, the bond market will let us know.
Who Pays For All This
Given the unprecedented level of stimulus spending, is inflation inevitable? To answer this, we should consult the wisdom of the bond market.
Bond market yields are determined by the consensus opinions of professional economists and traders, and the buying and selling decisions they make. These yields, in turn, express an expected rate of future inflation. Bond market professionals are well-aware that the government has thrown a tremendous amount of cash at the COVID crisis, and they understand the implications for inflation. In full awareness of these facts, as of May 31st the collective knowledge of the professionals in the bond market suggested an expected inflation rate of 2.57% over the next five years.
Although 2.57% is a higher rate of inflation than we have seen in the US for a while, it is certainly not comparable to the US inflation rates of the ‘70s and ‘80s. It may even be a welcome change if wages grow along with it. So, although significantly higher inflation is certainly possible, the bond market is sending a signal that it is far from inevitable.