WIf, just a few weeks ago, you thought inflation would fall significantly over the course of the year, you were in good company. Because this is the hope that most investors around the world have harbored and have now been caught on the wrong foot. The latest inflation data have clearly shown that neither the European Central Bank (ECB) nor the US Federal Reserve will be able to end their rate hike cycle in the foreseeable future.
The fact that investors now have to reorient themselves can be clearly seen from the development on the bond market. Yields there have shot up in anticipation of further increases in key interest rates in recent weeks and especially in the past few days. While the yield on the ten-year federal bond, which is the reference interest rate for the euro area, was below 2.1 percent four weeks ago, it scratched the 2.8 percent mark on Thursday. That’s a 0.7 percentage point rise, which years ago would have been tantamount to a tectonic plate shift in the bond market. But after the turnaround in interest rates last year, investors are used to violent fluctuations in the bond market, which used to be so stable.
Stock market remains stable
The stability of the stock market is astonishing in view of this sell-off on the bond market. The German share index Dax has still been up almost 10 percent since the beginning of the year. On Friday, the Dax was up 0.9 percent at 15,462 points. On Thursday, after temporary losses, it rose by 0.2 percent to 15,328 points, although figures on inflation in the euro area gave the ECB further ammunition for interest rate hikes.
The central bank should be less concerned about the 8.5 percent increase in consumer prices in February compared to the same month last year than the core rate (excluding the volatile energy and food prices). This increased to a record level of 5.6 percent and has deviated further from the ECB’s target value of 2.0 percent. In an interview with Spanish television, ECB President Christine Lagarde promised further rate hikes after the March meeting. “At this point in time, it’s possible that we can continue down this path,” she just said. At its meeting on February 2, the Governing Council of the ECB had already announced that the key interest rate would be raised by a further 0.5 percentage points in March. At that time he had raised the deposit rate by half a percentage point to 2.5 percent.
“The alarm bells are ringing at the European Central Bank,” commented Thomas Gitzel, Chief Economist at VP Bank. Inflationary pressure remains high: “Despite the rise in energy prices when war broke out a year ago and the resulting base effect, the rate of inflation is falling only slightly. That is frightening.” The service sector is passing on increased energy and personnel costs to the products.
Concerns about interest rates are not easing in the United States either, which is the largest and most important capital market in the world. On Thursday, the yield on the ten-year US government bond rose above the 4 percent mark for the first time since November. Here, too, investors are preparing for further rate hikes by the Fed. The stable economy gives the central bank the necessary leeway.
Reassessment of the price increase
For the analysts at Commerzbank, the reassessment of structural inflation, which is characterized by currently high core inflation, is progressing. Structural inflation stands for a permanent increase in prices due to fundamental factors such as a shortage of skilled workers or the relocation of production from cheap foreign countries back to domestic plants. For the analysts at Bayern LB, the rising key interest rate expectations underpin the fear of a later hard landing of the economy.
“Nevertheless, European equity markets have shown pretty good resilience so far,” they add. This is probably mainly due to the fact that the economy is doing better than was expected a few months ago. There has been no slump in corporate earnings, which has kept the stock market from crashing.
However, investors are increasingly concerned with the question of how long the stock market can resist rising interest rates. Because this makes fixed-income investments more attractive: At the short end, high-quality corporate bonds (investment grade) can earn between 4 and 5 percent comparatively risk-free.
Furthermore, the yield curves are inverse: at the short end, the interest rates are higher than the long-term ones. At 3.2 percent, the yield on the two-year federal bond is the highest it has been since 2008. That is almost half a percentage point more than the ten-year federal bond.