Inflation is high everywhere in the developed world – it’s all anyone’s been talking about for the past year. Central banks have been trying to combat this by raising interest rates. The ECB, for example, hiked its official interest rate on the 21st July, marking the first time that the Eurozone has had non-negative interest rates in almost a decade. The Federal Reserve began increasing its official interest rate in March this year, and it now stands at 2.25-2.50%.
The trick, of course, is to raise interest rates without causing a recession.
In the face of all this bad news – stubbornly high inflation, a potential recession, and the possibility of more rate rises in the future – markets have begun to rally. Equities, bonds, and precious metals have all posted strong returns over the past several weeks. What gives?
It is interesting to note that commodity prices have begun to fall again: the Rogers International Commodity Index – which measures the prices of a basket of commodities – has come down 14% from its peak. Federal Reserve Chair Jerome Powell also commented in late July that future rate increases may not have to be as aggressive.
With these facts in mind, the market rally begins to make sense. It is important to remember that markets are weighing machines – and they don’t weigh information that is already known, because that is already in the price. Instead, what they weigh is new information.
So when commodity prices began to decline, and Jerome Powell commented that future rate rises might not need to be as aggressive, the market took that information and concluded that: (a) inflation is likely to be tamed; and (b) a recession, if one occurs at all, has a reasonable probability of being mild since interest rates won’t have to crush demand too badly.
Framed that way, a rally appears logical – even reasonable! Of course, markets are just the weighted average of all participants’ opinions and are thus prone to error if participants are thinking in herds. In our view, it is hard to look at sticky mid-single-digit inflation and not conclude that interest rates have higher to go. Higher rates, of course, threaten recessions and lower corporate profits.
But that is the point: it is just our view. And one cannot be too dogmatic about it.
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