Rising Inflation and Interest Rates: What Investors Need to Know

With inflation now having reached its highest rates of increase since the early days of cable TV and Diet Coke, investors are facing the highest levels of market volatility since the initial COVID-19-induced sell-off two years ago. In addition, rapidly changing expectations of Federal Reserve policy in response to inflation have sent short- and long-term interest rates higher. As both inflation and interest rates are likely to keep increasing into the months ahead, we believe investors should keep the following points in mind. 

• We believe inflation reports, such as the consumer price index (CPI) and the Fed’s preferred metric, the personal consumption expenditures price index, will continue to remain hot into the second half of the year. The CPI for the month of January reported a year-over-year headline increase of 7.5% and a core (ex food and energy) reading of 6.0%. These are the highest headline and core rates of inflation since February and August of 1982, respectively.  However, as global supply chain challenges and worker shortages potentially begin to ease in the summer months and annual comparisons come up against the rising monthly reports of last year, there is a path, in our judgment, for inflation to subside toward the 3% range by year end.

• We are again raising our expectations regarding Fed rate hikes in CY 2022. We now see a strong probability of six quarter-point rate increases between now and December, with the federal funds rate likely concluding the year with a target range of 1.50%–1.75%. We also now believe the scenario of a 0.50% rate hike at or by conclusion of the upcoming March Fed meeting has become an increasingly higher probability, as the Fed is behind the curve on fighting inflation due to an overemphasis on job growth and misjudgment that inflation would be transitory during the past year.

• In addition to rate hikes, we also believe the Fed will soon announce plans to begin reducing its nearly $9 trillion balance sheet of Treasury bonds and mortgage-backed securities holdings. Such plans by the Fed to reduce bond holdings could amount to approximately $1 trillion annually for the next two or three years, which would also address the further end of the yield curve. Although longer-term rates have risen considerably since last summer, we believe there is likely more to follow as the 10-year Treasury yield could challenge 2.50% by year end.

• Higher inflation combined with the escalating numbers of COVID-19 cases during January could impact short-term economic momentum. Currently, the Atlanta Fed is tracking 1Q GDP at only 0.7% growth through February 10. However, we believe given what now looks to be dramatically lower COVID case trends over the past month and what could be mitigating inflation during the summer and autumn months, the economy could be shaping up to resume 3% plus economic growth in 2H 2022 and into CY 2023.  

We believe investors should brace for more volatility in the months ahead in the equity and credit markets as the inflationary and interest rate environment continues to play out. However, in our judgment, the economy could be setting up for large pent-up consumer demand in 2H 2022 and CY 2023 as declining COVID-19 cases potentially shift the virus from pandemic to endemic status, and the prospect of inflation eventually mitigates toward a 3% handle. Therefore, as such, stock and credit investors may find themselves well rewarded for staying the course during the months ahead.         

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