Rising Interest Rates and Inflation

By Dean Barber

February 26, 2021

Rising Interest Rates and Inflation

Key Points – Rising Interest Rates and Inflation:

  • Stock market performance so far this year
  • The COVID hangover and interest rates
  • The bond market
  • Inflation and money velocity
  • 6 minute read | 9 minutes to watch

We have the threat of inflation. We have stock markets with record levels as far as price-to-earnings ratios go. And we have a rising interest rate environment. So, where does all that bring us? Please join me with this episode of our monthly economic update.

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Rising Interest Rates and Inflation

We have a lot to talk about this month. You may be hearing rumors of inflation and stock prices being at all-time highs. Even that bonds may not the safe place to be either. So we’re going to break it all down here for you on this month’s economic update. 

Stock Market Performance Year to Date

Rising Interest Rates - Stock Market Performance YTD

Figure 1 | Source: Chaikin Analytics

Let’s start with the equity markets. Looking at Figure 1, we see the S&P 600, the small cap, at the top. Year to date, it is up about 15.38%. Then followed by the Russell 2000, up 13.11% mid cap higher by 9.86%. 

Moving down to the Russell 3000, that’s up by 4.64% year to date. One of our last year’s darlings was the NASDAQ, or QQQ. And many of the big tech stocks have taken a hit here late recently. 

But remember, the NASDAQ was up over 40% last year, and small caps just started making the run towards the end of last year. They have been on a tear so far this year. 

Money is Flowing into Small Caps

So we’re seeing a rotation of where money is flowing more into small caps, more into consumer cyclicals. The Dow is picking up some steam, and the S&P 500 is staying kind of steady overall right now. 

Inflation and Market Fears

All the markets look decent. The Fed seems to be very, very accommodative from their comments this last week. And so what I anticipate is that we’re going to see some volatility here. The big fear of the markets right now is roaring inflation. 

You may have seen headlines like we saw last week on CNBC about home prices up by 10.3%. If you look at what’s happening in all sectors of the economy right now. It’s hard to get goods shipped from one place to the next. There are shortages of many different things in the supply chain. 

The COVID Hangover & Interest Rates

All of that is still just part of the COVID hangover. Home prices are due to a dramatic drop in interest rates. So, with that as the backdrop, let’s step in and look at what’s happening with bonds right now. 

The Bond Market

Figure 2 | Source: Kwanti

So I’ve got two lines up here on bonds in Figure 2. The green line here is GG. That is simply the bond aggregate, and so on a year-to-date basis, the bond aggregate, AGG, is a negative 2.11%. 

On the year, we’ve got another one here, DPFAX. This is a mutual fund that holds senior secured debt and mortgage-backed securities. That sector of the bond market is holding up very nicely and should hold up very nicely in a rising interest rate environment. It’s up 2.24% year to date.

I bring this up because, you know, when people start talking about inflation, they start talking about rising interest rates, people automatically go, “Ah, bonds are going to lose money.” 

Well, that’s true with some bonds, but not all bonds. Some bonds do make sense in a rising interest rate environment. And remember that bonds are always meant to be the stay-rich assets. 

So even though you may see a negative return on AGG so far this year, it doesn’t necessarily mean that it’s going to continue to deteriorate. For that to happen, we have to see Treasury rates, the longer-term Treasury rates, the 10-Year plus treasuries continue to rise. 

Rising Interest Rates

Rising Interest Rates - 10 Yr vs Money Velocity

Figure 3 | Source: St. Louis Fed

So let’s take a quick look at what’s going on with interest rates right now. What we’re looking at here in Figure 3 is the 10-Year Treasury constant maturity. That is the right axis over and the blue line. So the little jump up that you can see in the bottom right on the blue line is what has happened so far this year. 

So the 10-Year Treasury so far this year has increased by almost 40 basis points from 1% to nearly 1.4%. Now, we still have a 10-Year Treasury at 1.4%. How bad can this be?

The bond markets are looking ahead and saying, “Gosh, when this COVID deal does get out of the way, and things start happening, the money supply is so big, it’s so big that you’re going to see runaway inflation!” 

The bond market is looking at that, and you start seeing that sharp increase in the 10-Year Treasury. That’s what the stock market is scared of right now. And that’s why I think you see a lot of rotation out of the high-tech stocks over into Dow type stocks over into small cap type stocks and consumer cyclicals. 

Those will do better in an inflationary environment and when the economy starts to reopen fully.

Money Velocity

Rising Interest Rates - 10 Yr vs Money Velocity

Figure 3 | Source: St. Louis Fed

The red line in Figure 3 is something called money, velocity. Money velocity is defined as how many times per year does $1 change hands. 

So if we go back here into the early 1980s in Figure 3, you can see that $1 was changing hands about 3.5 times every year. Since then, money velocity has been declining. Look how money velocity fell off a cliff during the COVID crisis on the far right of the chart. It’s just now starting to come back. 

This is going to lag by about a month. So we’ll have some more data on this later. However, this is what we’re going to look at when it comes to inflation. Will that money velocity picked back up? Will people start spending more money as the economy reopens? 

Inflation, Bonds, and Money Velocity

I think that’s what the bonds are looking at right now. But we have to have money velocity to cause inflation because many things come into play. Most people think that money supply, the amount of money in the economy, drives inflation. But it’s the velocity of money. Again, that is how many times per year is $1 changing hands.

Figure 4 | Source: St. Louis Fed

So let’s take a quick look at Figure 4 which shows money velocity versus money supply. This chart takes us back to the early 1980s. And again, the red line here, that’s your money velocity. That’s the decline of how fast $1 changes hands. The green line is M2 or the money supply. 

If it were true that money supply caused inflation, we would be seeing runaway inflation right now. But the reality is, the money velocity has to be there. 

Where is the Risk?

So, where’s the risk right now? The risk is this. If money velocity were to pick back up, even get back to where we were, say a year ago, and the money supply that’s out there today, that would be when to begin to get concerned about inflation. 

Another thing is that Jerome Powell, Federal Reserve Chairman, just said last week that he doesn’t see inflation being a threat in the near term. I take that to mean over the next 12 to 18 months. 

Looking at longer-term than that, we do have to keep our eye on it. Because I think that that the way that the economy is setting up right now, we could start to see some inflation, but I think that is probably going to be pretty benign over the next 12 to 18 months. I would anticipate this year that we might finish with GDP growing by maybe 2% to 2.5%. And that coming off of a horrible year because of COVID. 

We May See More Volatility

So with all that as the backdrop, what I anticipate we’re going to see is increased volatility. I expect we will continue to see the rotation out of some of the big tech names into more small caps and more consumer cyclical Dow-type stocks. So, we’ll keep a close eye on all of that. 

Of course, our goal is to make sure that we’re keeping an eye on what you have going on. However, more importantly, to ensure that your portfolio is structured to have the highest probability of meeting your financial objectives, your short, your intermediate, and your long-term goals. 

Keep the lines of communication open with your financial advisor here at Barbara Financial Group. 

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We’re happy to talk to you about any concerns you may have and some opportunities out there, and how we can help you. You can schedule a complimentary consultation below. 

Thanks for joining me for the monthly economic update.

Dean Barber Founder & CEO

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