Friday, July 15, 2022

Inflation is red hot but bonds are doing well. What gives?

So, inflation is smoking hot and the Fed is hiking interest rates by numbers not seen in decades. Normally this would be like the kiss of death for bonds. Yet after a sharp spike earlier in the year, bond yields have stabilized and even declined somewhat recently. And despite multiple warning signs of an impending recession, stocks have likewise found their footing and seem to be recovering a bit after the worst first six months of a trading year since 1970. Concurrently the US dollar is soaring against other currencies and gold, a traditional hedge against inflation, has gotten the snot pounded out of it over the last several weeks. 

What the heck is going on?

The answer is in two parts. First, a lot of traders think the inflation is peaking, and thanks to aggressive rate hikes, will start falling next year. Some of them are placing bets on that scenario. 

Secondly, and IMO probably more significantly, as bad as things are here, they are significantly worse elsewhere. Europe is an economic disaster area thanks to severe shortages of just about everything compounded by Russia's war in Ukraine. Add to this are the highly justified fears that Russia might cut off oil and gas exports to Europe and you have something resembling a controlled state of panic over there. There is serious discussion of gas and fuel rationing for the first time since the aftermath of World War II. 

Further is the slow reaction of foreign central banks to combat inflation which is worse in much of the rest of the world. Thus far it looks like in Europe the decision has been made that inflation is the lesser of evils and will need to be tolerated until the Ukrainian situation calms down and some normalcy returns to the broader economy. And it is even more pronounced in some less developed economies where inflation is so severe that it is threatening the stability of the country. Think Turkey, Argentina (a country with defaulting on their debt rivaling soccer for the national pastime) and Venezuela which, thanks to decades of socialism, was an economic basket case long before the pandemic. 

All of this is making the US dollar highly attractive. A lot of foreign money is pouring into US securities which is driving down bond yields, despite the high inflation, and shoring up stock prices. In short, the dollar is looking like the safest house in a crappy neighborhood right now. 

So, is there any upside to all of this for the average American? Not a lot, unless you are planning a trip abroad. In which case you will find your dollar delivering the best return in recent memory with all major currencies at multi-decade lows relative to the USD. If this continues it could prove injurious to the American economy as our goods and services will become more expensive to export and foreign goods and services will become cheaper. 

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