There is something wrong
Consumer Price Index
Today, the Bureau of Labor Statistics publishes the Consumer Price Index in the United States. The CPI is a set of consumer price indices and is considered a reflection of current inflation. At the time of this writing, the new CPI is not yet known, but it is expected to rise 4.9 percent year on year. Last month, the CPI was 5.0 percent. The reaction of the markets then was surprising. Whereas one would have expected a further rise in interest rates, the interest rate on 10-year US government bonds actually took a nosedive. At the height of the inflationary fears, these interest rates were still at 1.75 percent but fell to 1.25 percent last week. According to many, this is a riddle.
Trust in central banks
After all, little has changed in the existing scenario of economic recovery and a strong pick-up in demand. The shortages of raw materials, semiconductors, and personnel that have arisen throughout the economy have caused price increases not seen since the 1970s. For many, this was a reason to expect structurally higher inflation and the start of a new, rising interest rate cycle. The central bankers assuaged these fears and did not fail to emphasise that this sudden surge in inflation would only be temporary. For the time being, the central bankers are right. The prices of most commodities have fallen again a little, interest rates have fallen too, and stock exchanges are quietly rising. Investors have not yet lost confidence in the central banks.
Yet there is friction. The prevailing consensus assumes continued economic growth, made possible by very generous monetary and fiscal policies. Ultimately, the expectation is that we will return to long-term low inflation and low-interest rates. The stock market follows this scenario, and this belief may well continue for some time. Yet there is something wrong with this assumption. If the economy is indeed expected to grow strongly, interest rates cannot stay low forever. Yet that is what the bond market seems to imply at the moment. Actually, you could say that the bond market and the stock market contradict each other. While the one seems to price in lower economic growth with low-interest rates, the other still assumes a strong recovery.
Are other scenarios conceivable? Yes, certainly. The strong pick-up in economic growth could lead to overheating. Inflation might not be temporary and might not return to the low level we have become accustomed to for decades. At some point, the central bank will have to tighten. Probably too late, as it is assuming a different scenario. Intervening too late would mean a severe blow to the stock markets and possibly even economic contraction. Certainly not a desirable scenario, but not inconceivable.
Or is the bond market right?
Another scenario would be that the bond market is right, as it often is. The current fall in interest rates is already foreshadowing a slowdown in economic growth and the widely expected economic recovery will be disappointing. The virus may again be showing its meanest side or the current growth forecasts were simply far too optimistic. In that case, the fantastic profits that companies will be reporting for the second quarter may well have been the highlight. Growth may have already peaked and it will only slow down from here. Given falling interest rates and a strengthening dollar, this is not a bad scenario.
Consider Plan B
Whatever will happen, nobody knows now. But as an investor, it is best to take into account the possibility that your expectations may not materialise. Dropping out of the market entirely is not the wisest decision, as markets always recover after a fall. Or would this be the first time in history that this did not happen? It is much wiser to arrange investments in such a way that any blow is minimised. The recovery that follows will then also be much more pleasant. Recovering from heavy losses can take many years. And selling at the bottom rules out any possible recovery.