FUN WHILE IT LASTED:

[B]onds have a more direct relationship with inflation, which erodes the future value of fixed interest payments as well as the bond's face value at maturity. So in general, the higher the expected inflation rate, the higher the interest rate investors will charge to preserve purchasing power. If inflation were likely to stay high enough for long enough to cause big problems, we should see it in elevated long-term Treasury yields. Yet, much as everyone is hyping the new year's recent yield climb, as Exhibit 1 shows, the 10-year Treasury yield hasn't jumped alongside the inflation rate. It actually fell for a good four months as the inflation rate accelerated past 5.0%. Following a brief uptick, it fell again as the Fed started reining in QE, a development everyone thought would bring higher rates. Even with the recent uptick, today's 1.73% 10-year yield is right around where it was in late March, when the inflation rate was much, much lower.

The market knows inflation hit 7.0% last month, and it likely priced that outcome well before today's data confirmed it. It knows people worry about the implications. It knows that one political party is blaming corporate greed while the other party is blaming its opponent's spending plans. Yet it also knows that the culprit most apparent in the data--the supply chain crisis--is starting to ease up. It knows people surveyed in December purchasing managers' indexes across the US and Europe reported cost and logistics pressures are starting to moderate. It has seen numerous businesses' investments in increased capacity. It has seen the push toward vertical integration that larger companies are using in hopes of controlling their costs and destiny. And it has seen the inflation math evolve over the past year, so it knows that in a few months, lockdown-deflated early-2021 prices will be out of the denominator in the year-over-year calculation, removing the funky math helping skew the inflation rate higher. It has seen all of this and, based on where yields are, it has decided inflation isn't a major problem for stocks. This, coming from the most efficient pricing and forecasting mechanism on earth.

Yes, markets can be inefficient in the short-term--this is where corrections and bubbles alike come from. But it isn't in markets' nature to ignore something as big as inflation for over half a year. So, in our view, the most rational conclusion when the hype says one thing and the market says another is that the market is right. If it knows where inflation is and how people and businesses are responding to it and long-term yields aren't soaring, that is a powerful signal. Take a deep breath, and trust it.

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