Deflation to Inflation...
The course of the coronavirus pandemic has dominated stock swings since last year; and recently, inflation has emerged as a driving force in the market. Early in the pandemic, deflation was a concern. But now, inflationary forces have surfaced, as pent-up demand for services and travel, unleashed by widely available vaccines and reopening economies push prices higher.

Bond Bonanza
When lock-downs halted demand, deflation appeared as many businesses cut prices, trying to lure customers. Like economic quicksand, deflation can further zap demand as buyers delay purchases, waiting for costs to drop even more. Now, deflationary fears have been replaced by inflation jitters. To meet a potential oncoming flood of demand, companies may raise wages to attract workers, and also pay higher prices for materials. Higher costs may get passed to consumers. Bond investors have expressed expectations of rising prices through increases in treasury yields, with the rate on the closely watched 10 year bond surging more than 200% since August.

Leverage
Companies with high debt, often technology companies or newer start-ups, pay more to borrow when rates rise. The increased cost can weigh on stock prices. This was clear in March when interest rates reached a peak – the overall stock market dipped 6%, while a group of technology stocks dropped 12%. A long-lasting rise in prices could also prompt the Federal Reserve to act. Fed officials have said they see the pick-up in prices as temporary. However, investors may be concerned inflation will soar more than expected, forcing the Fed to raise rates.

Fed Funds Rate...
One of the most well-known Fed tools is interest rates. The rate the Fed charges on short-term loans it makes to banks, often called the Fed funds rate, ripples through the entire financial system and influences rates across the economy. When things get overheated, the Fed can raise rates, limiting lending to cool things off and hopefully avert a bust. During downturns, the Fed can lower rates to jump-start commerce. Investors are clearly looking ahead to a return to pre-pandemic activity, with the stock market over 20% higher than it was before the first lock-downs. And though stocks have recently recovered from rising interest rate-induced dips, investors may keep watching for signs of sustained inflation as well as clues to the Fed’s future path.

June 2, 2021