February saw the Dow Jones Industrial Average crossing 32,000 for the first time ever before closing the month up 3.2%. The S&P 500 and NASDAQ indices also saw modest gains for the month, rising 2.6% and 0.9% respectively — despite technology stocks suffering their worst day since October.

While bonds typically take backstage to stocks in financial markets, they got their time in the spotlight late in February. The 10-year US Treasury bond yield — a widely used proxy for interest and mortgage rates — surpassed 1.5%, representing a 66% increase from the beginning of the year. Unlike the federal funds rate, which is an overnight borrowing rate set by the Federal Reserve, 10-year US Treasury yields are primarily driven by investor demand.

This surge affected technology stocks, whose rich valuations have been justified by low interest rates. Technology and other high-growth stocks are valued based on future earnings, so higher interest rates makes those future earnings less valuable in today’s dollars.

While the faster-than-usual increase in bond yields raised some alarm bells, it’s important to keep in mind that even with the increase, interest rates are still at historical lows. The 10-year US Treasury yield rose above the 1.43% dividend yield on the S&P 500, making bonds look a bit more attractive for the first time in many months.

For many, the surge in rates is optimistic for the economy and implies a stronger and faster recovery than expected. Consumer spending is increasing, first-time jobless claims are declining, and (most important) the vaccine rollout is under way. And the FDA’s authorization of Johnson & Johnson’s one-shot vaccine will help accelerate the achievement of herd immunity. Add in the $1.9T stimulus bill that’s expected to pass next week, and the economy is poised for outsized growth.

Faster economic growth, however, comes with fears of inflation. Yes. Inflation. The thing-that-shall-not-be-named that worries investors and consumers alike. If inflation rises, purchasing power is diminished. Investors are also concerned that despite stated intentions to keep interest rates low for the foreseeable future, the Federal Reserve might need to increase them sooner than anticipated as a measure to counter inflation. Higher interest rates increase borrowing costs and put the brakes on economic growth.

Instead of going down an anxiety spiral of the what-ifs that could, would, or maybe should happen, let’s take a step back and unpack what’s actually happening now.

What exactly is inflation?

In the most general terms, inflation is the increase in the prices of goods and services, which subsequently decreases purchasing power within an economy. It is commonly measured using a price index such as the Consumer Price Index (CPI). The CPI is a measure of the average change over time in the price of a standard set of consumer goods and services, such as food, medical care, clothing, and transportation. For January, the CPI rose 0.3%, and over the last 12 months, it increased 1.4%.

What drives inflation?

When the demand for goods and services in an economy rises faster than supply and production capacity, that imbalance pushes prices up, which in turn drives inflation. And when inflation rises faster than wages, it causes a decrease in purchasing power.

We’ve been conditioned to think that any inflation is bad. Media mentions of inflation are often accompanied by the word “fear,” as in “Global Stocks Routed as Inflation Fears Dominate” or “Dollar Gains as Inflation Fears Push Yields Higher.” Despite the fearmongers, economists agree that a moderate amount of inflation is healthy for an economy. That’s because as the economy grows, demand for goods and services grows as well, which in turn drives prices a little higher. The increased demand also creates jobs and a demand for labor, which increases wages. And with those wages, workers can purchase more goods and services, driving more demand, and so on.

Of course, high unchecked inflation (such as the double-digit inflation of the 1970s) is harmful to an economy, but we are a long way off from that. It’s no secret that the Federal Reserve has a 2% average inflation target. Given how low inflation has been in recent years (1.3% since 2012), the inflation rate would need to rise above 2% for a period of time to reach an average of 2% over time. In fact, the Fed has signaled that it would accept a period of elevated inflation before increasing interest rates.

With the economy in near shutdown for almost a year, it wouldn’t be surprising for pent-up demand for goods and services to create a significant spike in demand as it opens back up, which would drive prices up. And that might translate into price increases that result in a higher-than-targeted inflation rate, particularly when measured from a pandemic-driven low of one year ago. One way to think about it is that growth needs to “catch up” to the economy’s pre-pandemic growth trajectory. Similarly, higher inflation for a period may be a necessary consequence for reaching a healthy level of inflation over time. This is called reflation, a form of inflation that represents a recovery of prices to their previous levels.

For now, expectations of higher inflation are good news for the economy — they mean it’s recovering more quickly than expected. And the bottom line for investors? We don't know if and when higher inflation will appear, so having a diversified portfolio that can hold up under different market environments, including assets that help protect against inflation, is key. Asset classes that historically have kept up with or outpaced inflation include stocks, TIPs (Treasury Inflation Protected Securities), real estate, and infrastructure assets. And while inflation can erode the real value of bonds (except for TIPs), they still play an important role in a well-diversified portfolio: reducing overall volatility and market risk.

Disclosures