The biggest ‘inflation scare’ in 40 years is coming — what stock-market investors need to know

“The result is that investors should be prepared for the biggest inflation scare in America on the reopening of the economy since the early 1980s when former Fed Chairman Paul Volcker crushed double digit inflation in the late 1970s by imposing high real interest rates on the American economy,” Wood said.

Up for debate is just how long-lasting any inflationary bout is likely to be — and exactly how the Fed will respond. The answers to those questions have implications for the overall stock market and individual sectors.

Data over the next few months will be closely watched, but any kind of near-term inflation scare is likely to be more of a “data quirk” tied to base effects, the recent run-up in commodity prices or kinks in supply chains, said Brian Nick, chief investment strategist at Nuveen, in a phone interview.

Base effects are the comparison with prices a year ago, which were often abnormally low as a result of the pandemic. That means inflation will appear pronounced even if prices are merely returning to pre-pandemic levels or moving slightly above.

The Fed, meanwhile, has made clear it doesn’t expect inflation to prove stubborn and is willing to tolerate an economy that runs hot and pushes inflation above its usual target of 2% for an unspecified period before pulling back on its extraordinary monetary stimulus efforts.

The 10-year break-even rate, sometimes viewed as what holders of Treasury inflation-protected securities anticipate consumer prices to average over the next decade, stood at 2.32% on Tuesday. That marks the highest level since mid-2013.

But prospects for inflation over a shorter-term horizon are even more heightened. The 5-year break-even rate was at 2.52% Tuesday, around its highest since 2008. Such inversions of the break-even curve — where short-term inflation expectations exceed longer-term expectations — are rare, and suggest that these investors expect a pickup in inflation that subsequently fades away, said Michael Arone, chief investment strategist at State Street Global Advisors, in a note.

But should investors share the Fed’s confidence?

“It might be easy for the Fed to dismiss rising prices as temporary, but with aluminum, copper, oil, lumber and housing all surging in recent months, it’s risky for investors to ignore the possibility that this may be a more permanent upward shift in prices,” Arone wrote.

Not all investors are convinced the Fed will sit on its hands as inflationary pressures pick up. Fed-funds futures traders have begun to price in rate increases for late 2022.

Meanwhile, the yield on the 10-year Treasury note TMUBMUSD10Y, 1.647% has risen significantly since February, trading as high as 1.77% — its level before the pandemic hit. Yields move in the opposite direction of prices. The yield on the 5-year Treasury note TMUBMUSD05Y, 0.843%, seen as more sensitive to Fed expectations, had led the way higher before moderating this week.

If expectations for an early liftoff by the Fed continue to rise it could force a “reckoning” this summer, said Nuveen’s Nick.

“The market is nearly always ahead of the Fed and nearly always wrong,” he said, but policy makers will need to be vigilant about communicating frequently if inflation data does run hot. The Fed will need to explain in “more wonky fashion” that the rise is happening for transitory reasons and that a tightening of policy remains 18 months to two years away, he said.

The environment created by Fed-related uncertainty does offer investors a “silver lining,” said Kristina Hooper, chief global market strategist at Invesco, in a March 29 note.

Other investors “can take advantage of ‘Fedspeak’-related selloffs, which can create tactical buying opportunities for investors with a longer time horizon,” she wrote. “And if markets actually become disorderly, I believe Powell will likely step in.”

Jefferies’s Wood argued that the Fed would be willing to “lock in government bond yields by adopting some version of yield-curve control, with the key timing question whether this is done pre-emptively or after a risk-off move in markets.”

In yield-curve control, a central bank targets a longer-term rate and pledges to buy whatever amount of long-term bonds are necessary to keep the rate below its target.

“Such an imposition of price controls in the U.S. Treasury bond market will introduce formally a regime of financial repression. It will also send the unspoken message that the Fed understands that the system can no longer stand higher interest rates politically,” Wood wrote.

Meanwhile, any hint of an early tapering by the Fed would trigger a sharp selloff in equities, he said.

But as long as the Fed doesn’t appear to be walking back its promise to hold off on tightening, rising rates will likely remain relatively benign, argued Nuveen’s Nick. While there was an opportunity to pick up some growth-related stocks that appeared oversold during the first-quarter rotation, improving data on the economy and vaccinations should continue to benefit cyclicals, he said.

State Street’s Arone argued that investors should take some precautions.

“To guard against the possibility of rising inflation, investors could consider replacing traditional bonds and growth stocks with growth-sensitive bonds and rate sensitive stocks to ensure portfolios remain diversified and meet their investment objectives,” he wrote.

Sunny Oh contributed reporting to this article.