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Why inflation's return has financial markets on edge

There’s a lot of noise out there. From the speculation on the presidential candidates, the various federal and state responses to COVID-19 and ongoing civil unrest. All of these factors have the potential to impact the US dollar, the world’s most widely-traded currency.

  • Inflation is the measurement of prices of widely used goods and services over time
  • After a decade of stagnant deflation, inflation pressure is rebounding with interest rates
  • Rising inflation generally leads to rising interest rates
  • As interest rates rise, currencies and share markets are impacted
 

Inflation, long absent makes a comeback

It was once the bogeyman whose very name sent fear down the spines of central bankers. Inflation has foreshadowed world war, toppled economies and governments and has been a motivating factor behind the creation of cryptocurrencies.

Since the Global Financial Crisis, inflation in the developed world has been non-existent, at least in the way we measure it, thanks to sputtering global growth, technological advancements and globalisation.

But now inflation is back, or perhaps more importantly, the markets are starting to believe that it’s back. Financial markets are starting to price higher inflation in the medium term, anticipating that central banks will have to increase their interest cash rates.

But what does this mean for currencies? Well, it’s complicated, but rising inflation can set off the below:

  • When inflation rises, central banks raise interest rates to slow spending
  • Higher interest rates attract foreign investment, increasing the demand for, and value of, a country’s currency
  • Higher interest rates increase the cost of borrowing and therefore can negatively impact the value of equities, prompting a sell-off
  • If these equities have been overvalued, a sell-off could cause extreme volatility to financial markets, boosting safe-haven currencies like the USD and hurting riskier currencies such as the AUD, NZD and CAD

Want to know more about how inflation, interest rates and currencies are interconnected? Read on.

What is inflation anyway and why is important?

Like that one glass of red wine you might drink for your heart health, inflation in moderation can be a good thing. If you’re a homeowner, house price inflation allows the value of your property to grow and build equity over and above your mortgage. Wage inflation makes us all feel that little bit richer in the new financial year.

Deflation, or falling prices, can also make us feel better off. TVs, computers, phones and phone data are all far more affordable relative to income than they once were. In general, however, deflation is a worrying occurrence for an economy. It’s usually linked to declining economic growth and once set in, can last for years. Japan’s “lost decade” of 10 years of stagnation and deflation from 1991 to 2001,1 was only turned around by an extraordinarily large fiscal stimulus.

Central banks attempting to prevent something similar happening in the West has been the defining activity in global economics, affecting currencies and stock markets. This means that understanding inflation and how central banks respond to it can be critical to understanding where a currency will go.

How inflation is measured

To measure inflation, government agencies put together a basket of goods that we regularly consume and compare it every quarter, this is reported in most countries as the Consumer Price Index (CPI). Typically, they’ll look at food and beverages, health costs, education, clothing, transport, recreation (e.g., sporting event tickets), furnishings, alcohol and tobacco, transport, insurance and housing (but not house prices which vary wildly according to location).

Why inflation is a key focus for central banks

Central banks try to keep inflation or deflation in check by using interest rates or monetary policy to control demand. By raising rates, they increase the cost of borrowing money so people invest less, and start saving. By reducing rates, the cost of borrowing is lowered, encouraging businesses and households to invest. It also encourages spending over saving.

Getting the formula wrong can cause severe economic pain. Raise interest rates too high and you might cause a recession; leave rates too low for too long and assets like property and shares can overheat. When those bubbles pop, like in the dot com crash of the 2000s and the housing crash that caused the Global Financial Crisis, deep recessions can follow.

Modern monetary policy is now focused on “inflation targeting”, a mechanism in which central banks set up the overnight cash interbank rate to manage liquidity while retaining flexibility to “let the economy run a little hot”, for example above 2% inflation, before raising interest rates. Otherwise, central banks can raise rates quickly if fears of a permanent pick up on inflation start getting out of hand, outpacing wage increases and affecting valuations.

Why inflation is rising again

To get economies out of the deep malaise of the financial crisis, central banks have been effectively creating money by buying government bonds from financial institutions via a tool called Quantitative Easing (QE). QE basically sets a ceiling on interest rates, to provide liquidity, ultimately encouraging spending. However, just as world economies were getting back on an even keel, the pandemic-induced recession forced central banks to double down on this strategy.

But as the vaccine rolls out and governments release large stimulus packages — US$1.9 trillion in the case of the US — economic prospects are suddenly looking a lot stronger.

The US Federal Reserve is tipping GDP growth to hit 6.5% in 20212 and unemployment to fall to 4.5% as stimulus-fueled recovery kicks the economy into top gear.

Critically, the US Federal Reserve has indicated it expects inflation to rise to 2.4%, albeit temporarily. 

Inflation front of mind for investors

Inflation is now being watched very closely by the markets. A survey by Bank of America found that inflation is the number one risk for investors, outweighing the pandemic3 Their big concern is that the prospect of rising inflation will force the Fed to start reducing or tapering QE or raising rates. 

The last time that happened, in May 2013, investors felt blindsided by then Fed Chairman Ben Bernanke raising the prospect of reducing QE and in a so-called “taper tantrum” sold bonds off heavily, causing treasury yields to shoot up and the US dollar to rise.4

How inflation expectations affect currencies

Government bonds, seen as safe investments, are valued on interest rates (or yields) according to maturity e.g., 5 year, 10 years. As interest rates go up, bond prices go down. Conversely, as bond prices drop, the implied yield rises. Bond investors are constantly making bets on future interest rate changes and buy and sell bonds accordingly.

We are now seeing bond markets starting to predict rising US rates in the medium to long term, beyond the 2-year mark. Because rising interest rates reduce the price of bonds, traders are selling down those long-dated bonds, and in the process pushing up the yields on them. 

It’s a highly circular relationship but critical to the way interest markets work.

The prospect of higher US interest rates is already having an impact on the US dollar. That’s because currencies tend to appreciate when their country’s interest rate rises relative to peers, thanks to the better yield on offer. Investors are always on the lookout for a safe place to earn a return so will park money where it is not at risk e.g., government bonds in financially stable countries.

Currency traders are aware of this phenomenon and will move into currencies where the prospect of rising rates exist, which is why tracking the 2,5 and 10-year bond yield is an important consideration when trying to gauge where a currency might go.

Inflation expectations can affect stock markets with flow on effects on currencies

Rising interest rates have an impact on equity markets too. Investment analysts value companies by discounting future cash flows using an investment formula called weighted average cost of capital. Interest rates are a critical input to that formula, so the higher that interest rate is, the lower valuations become. The recent declines in high-growth tech stocks5, are linked to such valuation concerns.

Which is why the markets are on something of a knife edge over inflation. Investors and companies have benefited for so long from central bank stimulus aimed at boosting inflation, that many investors are worried about what happens when interest rates rise to prevent inflation. Companies whose valuations looked attractive when rates were artificially low may not look so attractive anymore. Then, the famous Warren Buffett quote may come to pass: “You only find out who is swimming naked when the tide goes out." 6

As an earlier blog post foreshadowed, a big selloff on Wall Street tends to cause the US dollar to rise relative to other currencies, as investors globally seek the safe haven of the US dollar to wait out any potential crisis. As well as risky stocks, investors will typically sell off commodity currencies such as the AUD, NZD and CAD, causing a reduction in their value. Given the concerns about the US stock market reaching bubble territory7, major investors worry that a correction could be particularly painful.


1https://www.reuters.com/article/us-japan-economy-inflation-idUSKBN22C411
2https://au.finance.yahoo.com/news/fed-more-upbeat-us-economy-204625660.html
3https://www.cnbc.com/2021/03/16/investors-now-fear-inflation-and-the-fed-more-than-covid-bank-of-america-survey-shows.html
4https://www.theage.com.au/business/markets/asx-set-to-dip-as-wall-street-slumps-on-rising-bond-yields-20210305-p577zd.html
5https://www.businessinsider.com.au/ray-dalio-quotes-bubble-dynamics-markets-bond-yields-stocks-stimulus-2021-3?r=US&IR=T
6https://www.berkshirehathaway.com/2001ar/2001letter.html
7https://www.businessinsider.com.au/ray-dalio-quotes-bubble-dynamics-markets-bond-yields-stocks-stimulus-2021-3?r=US&IR=T

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