April 21, 2022
Bond & Equity Markets Appear to Have Divergent Views on the Impact of Inflation
Bond & Equity Markets Appear to Have Divergent Views on the Impact of Inflation April 18, 2022 | Nic Millikan | CAIS When the Consumer Price Index of inflation for …

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Bond & Equity Markets Appear to Have Divergent Views on the Impact of Inflation

April 18, 2022 | Nic Millikan | CAIS

When the Consumer Price Index of inflation for March came in this month at 8.5%, it not only hit another four-decade high, but it again exceeded the markets expectation for the rate of year-over-year price increases according to a Bloomberg survey. Interestingly, and despite the ongoing higher than expected pressures, after the release we heard calls across the market that we had reached ‘peak inflation’.1 Regardless of this view, the U.S. Federal Reserve (the Fed) doubled down on their commitment to raise interest rates to aggressively fight inflation2, while restarting the runoff of its more than $8.9 trillion dollar balance sheet.3

Interestingly however, both equity and bond markets appear to have set divergent expectations for the ongoing impact on inflation, which sees them now seemingly hold opposing views on the prospect of forward returns. While there can only be one future state of the market, this creates the potential for future volatility and dispersion in risk assets and could have very real implications for the future risk and return potential for both stock and bond markets.

Divergence in Implied Volatility

By looking at the expected implied volatility of an asset class, we may be able get a sense of what investors general expectations are for the dispersion of returns – the higher the dispersion, the higher the potential range of future returns, with the reverse also being true.4 Both the U.S. stock and bond markets have measures of short-term implied volatility. Stocks have the VIX, or the Chicago Board Options Exchange Volatility Index, and bonds have the MOVE, or the ICE BofA MOVE Index.

Currently, we see that the MOVE Index is trending higher and is approaching the level it was in March 2020, when the index hit a high of more than 160.5 The bond market appears to be taking its cue from the Fed’s hawkish stance on interest rates to stamp out high inflation and appears to be factoring in a volatile future state for bond markets. Conversely, we see that the VIX is trending lower and is currently below its 24.5 average since the end of 2019.6 The stock market appears to be expecting future returns to be less volatile, which could reflect the general view that we have reached ‘peak inflation’ and forward returns are unlikely to be greatly impacted by it.

This divergence, which started in October 2021, occurred after the Fed made it clear that it would begin to tighten monetary policy and remove liquidity from markets via its balance sheet roll-off,7 setting bond and stock markets on divergent paths for expected volatility.

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