Investors Are Betting Inflation Will Plunge. What If They’re Wrong?

Investors Are Betting Inflation Will Plunge. What If They’re Wrong?
Stéphane Renevier, CFA

over 1 year ago1 min

The conventional wisdom is that high interest rates and risky assets like stocks don’t play well together, given that the former makes borrowing so much more expensive and puts pressure on company profits. But ever since the Fed hiked US interest rates by another massive 0.75 percentage points on Wednesday, stocks have been soaring. So what gives?

Here’s what: most investors are now expecting inflation to fall off a cliff – a scenario that would enable the Fed to pause or even reverse its rate hikes and go back to supporting economic growth. We know they’re expecting this by looking at the “breakeven rate” (dotted line above), which falls when investors are betting inflation will drop off. It’s not perfect (there are technical features that slightly pollute the measure), but it’s a much more market-based and timely representation of where investors are expecting inflation to go than, say, economic surveys.

With that in mind, it makes sense that the stock market would rally. If investors are right – and if that drop-off in inflation doesn’t come at the expense of too much economic growth – stocks would be able to resume their long-term uptrend. But there’s no guarantee that the Fed’s rate hikes won’t tank economic growth, nor that inflation will fall as aggressively as investors believe. Either outcome would be problematic for stocks, and investors might live to regret buying back in…

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