Thursday was a bad day for bonds and stocks. If investors no longer believe that inflation is in control, there will be many more bad days. The yield on the US 10-year treasury increased the most in a single day since 2004, and crossed the psychologically significant threshold of 5%. But it is still below the last peak of June 2006. US and European equity indices dropped by more than 1%, but they are still up in 2007.
Still, something important may have changed—the perceived risk of inflation. Most central bankers have been fretting about inflation for months, but until this week, many traders didn’t really believe them. Forecast changes from two big Wall Street firms helped change the mood.
With no signs of disinflation, it now looks like the US Federal Reserve Board and the European Central Bank will keep on pushing up rates until pricing pressure is under control. They may have to push quite far. In a world of ample liquidity, higher rates on their own don’t seem to do much. The US move from 1% to 5.25% has tripped up the housing industry, but consumers can still borrow and spend to keep disinflation away. Credit spreads remain narrow and investors’ risk appetite has barely begun to diminish. It looks like both short-term rates and the expected future rate of inflation are heading up. That combination is likely to lead to higher bond yields. In turn, higher financial expense and wage pressure could cut into currently high corporate profits, hurting the stock market.
More frightening is the possibility that the end of easy money will cause a crisis in the financial markets, which have come to rely on a virtually unlimited supply of funding. With so many investors running leveraged portfolios, a crisis could easily spread. Pessimists have vainly predicted the end of good markets for years. Thursday’s tumble could be yet another false downward start. But now that central bankers are on their side, the pessimists’ hour may finally be at hand.