Inflation growth and equity markets
US indexes (SPY) are reaching highs as investors ignore possible threats of the US pull-out from the Iran nuclear deal and focus on increasing crude prices. Markets have been driven higher by surging energy company stocks (XLE), which are expected to reap the benefits of higher crude oil prices. On May 10, the Bureau of Labor Statistics’ inflation (TIP) report gave investors another reason to pile on risk, with April inflation growth coming in below expectations, at 0.1%. This lower-than-expected inflation growth calmed investors, who have been worrying about a faster pace of rate hikes from the Fed, which may take a step back if inflation growth continues to decline.
Why equity investors are concerned about inflation
Higher inflation growth could force the Fed to increase rates at a faster pace, which could increase borrowing costs for US businesses. US businesses have been enjoying low interest rates for more than a decade, and a sudden increase in rates could dent their profit margins. Higher federal rates would translate into higher yields for corporate bond (BND) issues, which large corporations use to fund their requirements. As this scenario could be negative for equity asset prices, any chance of higher rates impacts equity markets.
Could the Fed go ahead with faster rate hikes?
As of May 10, the odds of a June rate hike were above 90%. It’s possible that the Fed goes ahead with a second rate hike this year in June, and another hike in September. Whereas the possibility of a fourth hike in 2018 remains questionable, if inflation (VTIP) lags, we can expect the Fed to avoid a fourth rate hike. The only problem is that inflation could heat up with rising wages and higher gasoline prices. In the next part of this series, we’ll explain why bond yields fell after the inflation report.