With rates on the rise, investors fearing any signs of inflation

With the sharp move higher in interest rates, markets have been on the lookout for inflation creeping up.

So Wednesday’s December CPI will be important even if it still shows a muted rise in the consumer price index. According to Dow Jones, economists expect an increase of 0.4% month over month, and 1.3% year- over- year. Core CPI, less food and energy, is expected to be up 0.1% or 1.6% year-over-year, versus 0.2% and 1.6% in November.

The rapid move higher in bond yields since the start of the year has been accompanied by rising inflation expectations. The 10-year breakeven, a bond market instrument for inflation expectations, was at 2.07% Tuesday, suggesting investors expect inflation to average that level for the next 10 years. It was as high as 2.11% last week.

“I do think inflation is a real game changer should it occur. That certainly  is why rates are rising,” Jeff Gundlach, Doubleline Capital CEO said on CNBC this week. He said he expects CPI to reach 3% by May or June.

Covid has had a unique impact on inflation. Prices fell sharply when the economy shut down last year, and there’s been an uneven impact on the economy and prices. Rents for instance have fallen sharply, but home prices are rising. Strategists said while service sector prices are depressed, goods prices are rising.

“Once you get to March, April, May, you’ll start to get easy comparisons. You’ll see 3% inflation,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group. “I think the pressures are building and that’s going to be the key story for 2021.”

Rising interest rates have already sent a chill through some big tech and growth stocks, so the stock market could be sensitive to any pick up in inflation. One factor behind the increase in yields is the expectation that inflation will pick up as the economy reopens and as the government stimulus fundsk work through the economy.

Since the start of January, the 10-year Treasury yield climbed almost 25 basis points, to as high as 1.18% Tuesday, before it fell back to 1.14%. “I guess we’re not prepared for a big inflation number tomorrow,” said Chris Rupkey, chief financial economist at MUFG. “Inflation is supposed to be up a little, but it’s basically gasoline prices at the pump went up…Whatever inflation there is is likely to be strictly energy-related and Fed Chairman Powell said they’re not going to respond.”

Rupkey said there could also be some goods inflation, resulting from consumers getting home deliveries instead of shopping in stores.

Frustrated by a lack of inflation for years, the Fed changed its inflation policy so that it now targets an average range instead of its 2% target. That means inflation could rise above that 2% level but the Fed wouldn’t change policy unless it persisted at a higher rate

“Somehow inflation has been put on the back burner of Fed concerns. They’ve all kind of moved to full employment as a key indicator,” said Rupkey. Though far in the future, rates strategists said the market is already full of speculation that a pop in inflation could drive rates higher and ultimately prompt the Fed to move its own zero fed funds target rate.

“I think the market is sort of struggling with the potential negative of higher rates on one hand, and what that can do to compress multiples. But on the other hand, telling themselves rates are rising because we have the rollout of the vaccine, and therefore stay positive on risk assets. It’s like a tug of war,” said Boockvar. “I think inflation is the worst nightmare of inflated asset prices…for high multiple stocks, inflation is not their friend.”

St. Louis Fed President James Bullard Tuesday acknowledged prices should rise later this year. “Inflation looks set to move higher amid rising price pressure expectations,” he said in an interview, noting he expects more inflation in 2021 and 2022. 

“I’ll repeat again my belief that the Fed will finally get the inflation they’ve been yearning for and then some, in spite of their policies, and they will eventually regret what they’ve been wishing for as will the bond market and anything priced off it,” noted Boockvar.

The CPI report is released at 8:30 a.m. ET.