The Fed is set on a rate-raising trajectory, largely because of burgeoning inflation. Jim Bianco with Bianco Research, who recently held a conference call titled Regime Shifts Are Not Pretty, takes a look at how the transition from a deflationary environment to an inflationary one is throwing a monkey wrench in expectations about the economy.
Perceptual Shift in Play
When it comes to the relationship that interest rates have to risk markets, the perception for a long time was that higher interest rates are bad for the stock market. This held from the mid-1960s to about 2000, Bianco noted, but since 2000, higher interest rates were generally perceived as good for the stock market.
The reason for this is, between the 1960s and the 1990s, the primary concern was inflation. Whenever interest rates went up, that was a signal that inflation was coming, Bianco stated, and when interest rates went down, there was relief that no inflationary pressure was imminent.
Since 2000, deflation took the lead as the largest concern. Interest rates went down because we were worried that we were in deflation, Bianco noted, hurting stocks. Thus, as interest rates went up, relief set in under the prevailing belief that we weren't experiencing deflation.
“We're arguing that we're shifting,” Bianco said. “We're returning to an inflationary mindset, and the reason we're pushing 3 percent on the 10-year note and possibly higher is that we're worried that inflation is returning. The response has been that stocks are unchanged on the year despite booming growth and spectacular earnings.”
Two Narratives at War
The prevailing sentiment that we see in economic surveys is that everything is great, Bianco noted. Despite the strong environment, most aren't making money in the stock market. This is in part due to the shift to an inflationary mindset, Bianco stated.
Higher rates are a net negative on the economy, he added. The larger negative issue to be concerned about is higher borrowing costs, higher costs of capital, and a general drag on the economy from the increase in interest rates, unless inflation kicks in and justifies the Fed's stance. It is projecting six rate hikes between now and the end of 2019.
