Equities and bonds tend to be positively correlated in high-inflation environments. While equities perform best under low and stable inflation, rising inflation beyond 2-3% leads to devaluation of both asset classes, with investors favoring real assets instead. Commodities are expected to perform in this configuration.
While inflation has been decelerating in the US and globally, there is increasing evidence that it could prove more persistent than expected and continue to stay above official targets over the coming months.
Despite headlines of Quantitative Tightening, the Fed has been using implicit tools to provide “stealth” liquidity since 2022 and acted to maintain relatively loose financial conditions, in turn supporting financial markets and the economy. They lately decided to start cutting rates regardless of the resilient economy and despite missing nearly all inflation targets.
Similarly, the US Treasury has been indirectly supporting risk assets and the economy by shifting the issuance of debt towards T-bills and shorter dated coupons. The resulting scarcity of longer-dated coupon bonds drove Treasury bond prices higher and yields consequently lower.
These actions were likely designed to cap yields to support economic growth and avoid spiralling interest payments which are already expected to jump by 18 to 20% next year. Additionally, commercial banks are eagerly buying these shorter issuances to fulfil their specific needs. This monetization of fiscal deficits has historically proven to be inflationary.
Finally, the anticipated Trump policies could lead to demand-pull inflationary dynamics (increased government spending, reduced taxes), cost-push inflation (tariffs and trade barriers, reshoring of supply chains) and wage-price spiral (tighter immigration leading to smaller pool of workers and therefore higher wages).