Inflation has skyrocketed in Q3 while benchmark yields have moved lower. Yet these dynamics are not as inconsistent as they currently appear, and persistent inflation and low interest rates could continue well into 2022. We update our interest rate outlook and the link to policy. Looking ahead, investors should keep a close eye on inflation and markets will continue to focus on interest rates.
Inflation has been on a fast uptrend in 2021. Consumer prices accelerated from 1.4% year-over-year in January 2020 to 5.3% in August, driven by reopening-related price corrections, supply shocks and on-going economic changes due to the pandemic. Yet during this period of surging inflation, interest rates have fallen: The 10-year hit 1.74% in March but has since been on a choppy downtrend, trading as low as 1.17% in early August. This divergence has occurred as our economy has maintained growth at a breakneck speed. In Q2, GDP rose 6.6%, about three times faster than its underlying potential growth.
Historically, these three trends are inconsistent, which has caused a narrative to develop that something needs to correct in line with the others. The conclusion of this narrative often becomes that interest rates will naturally have to rise, particularly because the Fed is now starting down a path of policy tightening. However, our view is that historical comparisons have little place in the current economic or financial market climate.
- While annual inflation may have crested, price pressure may persist.
- Market measures of inflation expectations show modestly higher inflation into 2022.
- Multiple factors are exerting downward pressure on interest rates.
- Market sensitivity to interest rates has intensified.