A return in inflation? Undercurrents in the market are surging, and investors need to respond carefully

Prior to the Federal Reserve meeting last month, investors believed that inflation was over: price growth in August fell to its lowest point in three years, and fell below 3% in July. But now, the risk of rising inflation is increasing, as evidenced by developments in the bond market. The 10-year Treasury yield closed at 4.072% on Friday and has been rising every week for the past month. The high yield on long-term debt indicates that investors want more returns to deal with the risk that inflation may rise in the future.

The rise in the “breakthrough inflation rate” over the 5- and 10-year periods indicates an increase in long-term inflation expectations . These figures closed last Friday at 2.25% and 2.33%, respectively, and have reached their highest level since the summer. The bond market was closed on Monday due to Columbus Day.

What causes investors to be wary of inflation? It all started with the Federal Reserve's decision on September 19 to actively cut interest rates by 50 basis points. This has made borrowing cheaper and easier, and recent indicators show that the economy is still strong. The US added 100,000 more jobs than expected in September, and the service sector is booming.

Coupled with actions by the European Central Bank, the bank cut the benchmark interest rate by 25 basis points in June and September, respectively, and it is widely anticipated that similar measures will be taken this month. “This is the best time to be cautious about inflation,” Deutsche Bank macro strategist Henry Allen said in a research report on Monday morning.

The escalating conflict in the Middle East has boosted oil prices, and the upcoming US election is also one of the macroeconomic factors causing concerns about inflation. Both candidates proposed policies that could trigger inflation to attract voter support. Kamala Harris proposed tax credits to help people with newborns and home buyers, while Donald Trump proposed extending tax breaks for the rich.

If the two candidates' plans are implemented, they will both give people more money to spend, which may drive up prices.

Last week's higher-than-expected inflation report was also a warning. According to September data, the three-month annualized increase in the core consumer price index reached 3.1%, the highest level since May. Although this is just a report, it highlights the potential for inflation to persist, Alan notes.

At the same time, a lesser-viewed indicator of money supply within the financial system is slowly rising. The money supply measured by M2 increased 0.6% year over year in April, the first annual increase since November 2022. Since then, the money supply has continued to rise, indicating that more and more money is available to chase limited goods and services.

According to Ed Yardeni, a recent wage increase for dock workers may also cause import prices to rise, thereby driving up inflation.

The point is that another strong inflation report could plunge the market into chaos. Alan reminded readers of the “inflationary 1970s,” when investors experienced major losses in the stock market and bonds due to the 1973-1974 Arabian oil embargo, and crude oil prices soared.

In 2022, the S&P 500 dropped 19% when the Federal Reserve began raising interest rates to cope with a 9.1% surge in inflation in June. The bond market also declined.

Rising inflation doesn't just mean rising prices for supermarket goods and services. Its potential blow to stocks and bonds means household net worth could be affected. Although the net worth of American households soared $2.8 trillion in the second quarter to a record $164 trillion, nearly a quarter of that came from holding company shares, according to the latest Federal Reserve data.

A large number of people's wealth is linked to the stock market, so rising inflation may affect the ability to save and spend.