One year ago, a rapidly escalating virus brought the world to a stop, shattering the financial market. The prices of almost all risky assets plummeted, except for those of Treasuries. Fear of deflation and recession gripped everyone’s hearts. Now, due to the approval and distribution of effective vaccines, people have high hopes for the foreseeable future. But another doubt overshadows the current exuberance of the financial market, and this time, the culprit is fear of inflation.
A correct gauge of inflation places the foundation for the pricing of every financial asset. In theory, asset price is determined by the discounted future cash flow at the current interest rate, which equals real interest rate plus inflation rate. If the inflation rate shoots up unexpectedly, the asset price must be lowered. That’s essentially what’s been happening in the financial market the past few weeks.
Will the government’s monetary and fiscal plans against COVID-19 finally reverse the four-decade-long downward trend of inflation (Figure 1)? Or will it see a fleeting spike before resuming its long-term trend?
Thanks to the massive scale of the QE program and fiscal aid, and the unexpectedly fast rebound of economic activities, a common assumption is that money will inundate every corner of the economy, especially at the bottlenecks of the huge economical machine. However, after an initial spike of inflation due to pent-up demand, the inflation rate will more than likely revert into a long-term trend, although other inflation drivers may emerge. Factors that contributed to low inflation rates in the past will persist into the future. First, age distribution statistics show that the population, on average, is becoming older, a phenomenon that will only begin to reverse around 2040 (Figure 2). Older people tend to save more than they spend, which is deflationary. Also, although the technology revolution has slowed over the past few years; the recent lockdown has popularized the use of new technologies such as virtual meetings and 3D printing. The resulting saving in the labor cost is another deflationary factor. On the other hand, in the future, changes such as reverse globalization and efforts to decrease the inequality gap may make inflation rate rise, but it all depends on the political agenda.
In my experience rapid, excessive, and out-of-hand inflation tends to cause major issues for the economy. A one-time shock without further fuel is benign. The FED has the toolkit and should play a key role in guiding the market expectation.
If the yield on Treasuries continues to rise and results in an increase of borrowing cost, some companies could be unable to sustain them. Some of them should have already gone belly-up before COVID-19, but were rescued by extremely low-cost financing. Because of this, the continued yield increase to a certain level may slow down the economy. Bonds could also become more attractive to investors. The resulting liquidity in the bonds market would effectively bring down the yield.
The dynamics between yield, inflation, economic growth, and FED are always linked. To impulsively change our course without understanding the complexities in their interactions will evoke excessive trading. Let’s see how the story evolves this time.
This information has been designed for general informational and educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any security. Such offers can only be made where lawful under applicable law. These materials have been obtained and derived based on information from public and private sources that Pearl Wealth Management LLC believes to be reliable. However, no representation, warranty or undertaking, stated or implied, is given as to the accuracy or completeness of the information contained herein, and Pearl Wealth Management expressly disclaims any liability for the accuracy and completeness of this information. Pearl Wealth Management does not intend to provide investment advice through these materials and does not represent that any market position, economic forecast, securities or services are suitable for any investor. Investors are advised not to rely on these materials in the process of making a fully informed investment decision and they do not render business, tax or legal advice. Each client or prospective client should consult his/her own attorney, business advisor and tax advisor as to legal, business, tax and related matters concerning the information contained herein. The information, opinions and views contained herein have not been tailored to the investment objectives of any one individual, are current only as of the date noted and may be subject to change at any time without prior notice. Past performance does not guarantee future results. All investing involves risk of loss including the possible loss of principal.