‘Tug-of-war’ developing between economic reopening and inflation concerns

The first quarter of 2021 has gotten off to great start with equity markets continuing to achieve record highs. As we begin the second quarter, a tug-of-war is developing as investors weigh the prospects of economic reopening amid the vaccine rollout against concerns of rising interest rates and the prospects for inflation.

As the first quarter came to an end, the latest ($1.9 trillion) COVID relief package was signed into law, the vaccine rollout accelerated, state and local governments began lifting their lockdowns, and the Federal Reserve has reiterated its intent to remain accommodative. The U.S. economy and job market are beginning to show significant signs of recovery, and consumers are regaining their confidence. These positive trends contrast starkly with those that prevailed a few quarters ago. Consensus forecasts now call for real GDP (growth over inflation) to grow at a 6.5% annual rate, a level that we have not seen in 50 years, and some economists believe that this forecast is conservative.

Rising Interest Rates and The Question of Inflation

Against this backdrop, interest rates have accelerated, with the yield on the bellwether 10-year U.S. Treasury more than tripling from 0.52% in August of last year to 1.74% recently. Such a rise has investors wondering: Is inflation just around the bend? How high might rates go? What is the implication for stocks, bonds and the economy? These issues will be under a microscope as the economy reopens and as tax and economic policy flow from the Capitol in the coming months.

It is important to separate the question of whether rates can rise (they can and do quite often) from the question of whether rates are likely to remain high (much less certain). There are several reasons that interest rates might recede and/or stay low for a considerable period.

First, interest rates in the US might be low by historical standards but remain very high when compared to other developed economies around the globe.

This dynamic suggests that rates in the U.S. may have “less room to run” than rates in other developed economies.

Second, the virus put a massive halt to economic activity, and it may take a long time for it to fully recover. While GDP growth is very likely to spike upward from pandemic lows this year, the severity of the downturn and the associated impact on households, small businesses, commercial real estate, etc. are likely to have lasting effects that may constrain growth for years to come. This, in turn, may limit the degree to which rates and corresponding inflation will rise.

Third, while government stimulus might be perceived as inflationary, high debt levels may actually put a drag on economic activity, again constraining inflationary growth and interest rates. Research done by Charles Schwab illustrates this phenomenon: In recent years, while the growth of debt has expanded in the US, inflation has decreased, not increased. Over the last few decades, while public debt as a percentage of GDP has expanded substantially, inflation generally remained at or under 2%.

In sum, there is a good chance that the upward trend in interest rates and inflation expectations are “transitory” and will likely stabilize, and possibly recede, in the coming quarters. If so, that would be positive for the markets.

Eric Toole, MBA, CFP(R), is a Principal at Antares Wealth Management. He can be reached at etoole@antareswealth.com.