Global inflation has been on the rise in the aftermath of the Covid pandemic. It especially worsened due to the ever growing logistical costs needed for the global supply chain to function properly. The Russia-Ukraine conflict has only made matters worse.
Central banks have two major tricks, or levers, they can pull to direct the pace of economic growth. One of them is controlling the money supply, whether to print more money and lend it cheaply, or buy back existing sovereign debt. The other is the base interest rate.
During times of inflation, or when it is anticipated, central banks tighten their fiscal policies to slow the pace of economic growth. This has a direct impact on central bank policy as it is usually done by raising the interest rate.
While the Bank of Canada raised interest rates just last month, the other major central banks, Bank of England and the Federal Reserve, for example, have hinted at similar possibilities.
A higher rate has consequences for financial markets because it makes borrowing a little more expensive. This is by design as the objective is to make borrowing less attractive to private investors with the hope of reducing economic activity. This gets investors to buy sovereign bonds instead of raising finance.
Although a 0.5-1% increase might not matter to some corporations, a rise in interest rates, especially when they have remained low for several years signals to the market that ‘Quantitative Tightening’ might be in effect.
This creates a sentiment amongst investors to shift their focus towards government bonds because of the higher markups being offered as a direct result of the rise in interest rates.
Most investors, especially institutional investors, tend to alter their investment strategies to align themselves with their central banks’ policies. They start preferring bonds instead of dividend producing stocks of mature corporations.
However, both Goldman Sachs and J.P Morgan have the opinion that altering investment strategies from trading stocks to buying and holding bonds might be premature at this stage.
This shift sometimes results in lower stock prices of these corporations, and because large ones are usually part of indices, like the S&P and the DOW, the indices also start showing a negative outlook.
This has a trickle-down effect on corporations not part of indices and their stock prices also become vulnerable to the negative economic outlook. Ultimately and if not managed properly by central banks, a recession also becomes quite likely.
* Schneider, Howard; Koranyi, Balazs; Kihara, Leika (11. March 2022). Reuters: Global central banks stay inflation-focused, see growth continuing despite war. Last viewed on https://www.reuters.com/business/finance/global-central-banks-stay-inflation-focused-see-growth-continuing-despite-war-2022-03-10/#:~:text=The%20Bank%20of%20Canada%20raised%20interest%20rates%20earlier%20this%20month.