How Sensitive Are Rates To Economic Growth & Inflation?

With such low rates for such a long time, almost everything that has done well in the past few years has at least been a partial bet on duration. Macro is important. The investors in growth stocks that have been helped by low rates won’t deny that. They either think they can’t predict where rates will go, or they think rates will stay low.

There are 3 important variables here. The first is how sensitive rates are to economic growth and inflation. It doesn’t take much of a cyclical recovery or higher inflation to get the 10-year yield up when it’s at 50.8 basis points like it was at on August 4th. The recent rise to 71.8 basis points occurred with some improved economic data points and higher PPI and CPI than expected. We will review the CPI report next.

The second variable is how sensitive various assets are to a rise in rates. We saw an initial reaction to this recent rise as precious metals and tech stocks fell late last week and early this week. However, gold turned around on Thursday and the Nasdaq 100 rallied on Wednesday and Thursday even as the 10-year yield went up. As of Thursday, the yield had increased 5 days in a row (to 71.8 basis points).

The final variable involves the long game. The Fed is pressing hard to push inflation higher with some FOMC members even suggesting above 2% inflation is okay even though 2% is their target. The question is what happens to markets if the Fed pushes for inflation when inflation is higher? There’s no fear of inflation when it is very low. When inflation increases, there could be a major shift if the Fed doesn’t become more hawkish. It’s difficult to say what will happen because the Fed could always act prudently when inflation increases. However, right now the Fed is trying to learn from its mistake late last cycle when it raised rates and shrunk the balance sheet. The Fed is more afraid of repeating that mistake than high inflation.

Inflation Increases

The July CPI report was in tune with the PPI report. Monthly headline CPI was 0.6% which doubled expectations and matched June’s reading. Yearly headline CPI was 1% which beat estimates for 0.8% and June’s reading of 0.6%. Food and energy were countervailing measures as food inflation was 4.1% and energy inflation was -11.2%. Core CPI was also 0.6% which tripled both the estimate and the prior reading. Finally, core CPI was 1.6% which was above the consensus of 1.1% and June’s 1.2% reading.

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