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2 notable highs this week: Stock prices and inflation expectations

October 22, 2021, 8:34 PM UTC

The stock market hit a recent high this week, but so did something else: inflation expectations.

On Thursday, 10-year breakeven inflation expectations—or what the market on average expects inflation to be in the next 10 years—surpassed the recent peak it hit in May to reach 2.64%, the highest level since 2012, based on data from the Federal Reserve Bank of St. Louis.

That’s above the Fed’s long-term target of 2% inflation, and comes as supply chain issues are pushing up consumer prices and surging energy prices could weigh on growth and fuel inflation. The concern would be that inflation, which the Fed and many others have largely called “transitory,” may rest at a higher rate for longer.

But what does this mean for investors?

Inflation concerns have been ratcheting up in recent months along with the consumer price index (CPI), and this year there have been some bouts of weakness in the stock market after the 10-year Treasury yield has risen, especially for growth stocks that do well with low interest rates, like tech stocks. But by and large, yields have risen along with stocks this year, with the 10-year Treasury yield hitting above 1.5% in September for the first time since June and currently resting around 1.66%, while the S&P 500 is up over 20% year to date.

“If the Fed has to tighten much faster than it thinks because inflation levels are huge, then yeah, that could eventually cool the market a bit,” Randy Frederick, managing director of trading and derivatives at Charles Schwab, tells Fortune. “But generally when you have a rising rate environment, markets do well because it usually means the economy is cooking and doing fine,” he says.

The Fed is expected to begin tapering its asset purchases before year’s end, but the question about whether there will be rate hikes (and how many) next year is still up in the air. Lately, the market seems to be pricing in that rate hikes will happen next year.

Frederick argues the “market does see inflation and is expecting it, but also believes that the Fed is ready to move to control it.” If, however, the Fed doesn’t hike rates while inflation keeps rising, he notes that “could eventually be a drag on some parts of the market.”

Looking ahead

But investors, at least so far, don’t appear too anxious. On Thursday, the S&P 500 notched its 55th all-time high in 2021, hitting 4,549.8 points, with stocks up over 20% for the year (the index closed down roughly 0.1% on Friday). According to Ryan Detrick, chief market strategist at LPL Financial, Thursday’s record marks the most all-time highs in a year since 2017, he noted in a tweet.

A big reason for that? Third-quarter earnings. According to Frederick, “stocks are doing well right now because frankly, earnings have been great.”

Indeed, Lindsey Bell, chief investment strategist at Ally Invest, suggests that while rising inflation is certainly on investors’ minds, they still appear to be bullish. “Right now it seems like the market is feeling more optimistic about the potential for growth offsetting any inflationary concerns, even if the 10-year breakeven is moving higher,” she argues. “So I think it’s just a push and pull—right now, we’re in that pro-growth camp.” She believes the big concerns about inflation are more short-term, mainly in 2022. Indeed, bullish sentiment is on the rise, based on a big recent jump in the AAII Investor Sentiment Survey.

Mark Haefele, chief investment officer of UBS Global Wealth Management, is among those who are more optimistic: “The pandemic showed us that markets can look past challenging periods—provided they are not permanent,” he wrote in a Thursday note. And according to Haefele, “small increases in inflation expectations can be positive for markets if it helps to banish fears of deflation.” By his estimation, “global growth remains strong, supply chain challenges should recede into 2022, and corporate earnings should continue to grow,” he argued.

But in the near-term, one thing that could pose a potential snag in the market’s upward trek, according to Bell and Frederick: more drama around the government’s postponed debt ceiling debate, now slated for December.

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