As happens occasionally, the view of the world one sees expressed in fixed-income prices seems quite different from the one seen in equity markets. Today, however, the divergence is more evident in the price of volatility than it is in the price of industry benchmarks.
The S&P 500 is hovering near all-time highs, seemingly unconcerned about rising inflation or Covid, while US Treasury yields have ranged from 1.4% to 1.7%, reflecting perhaps a more balanced view of the current environment.
Volatility indices reinforce the view that equity markets are sanguine, while for fixed income markets, they point to perhaps greater nervousness. The VIX index, which measures expected volatility for the S&P 500, is near the lows for the year, while the MOVE index, which measures Treasury yield volatility, has touched a high for 2021 (see Exhibit 1).
Why the divergence? For now at least, equity markets are focused on strong economic growth and a much-better-than-expected third-quarter earnings season. Instead of crimping profit margins, higher input prices and wage costs have been passed on rather easily to consumers. The ratio of sales prices to input prices has started to rise. Besides raising nominal growth rates, rising inflation is encouraging consumers to buy now before prices go even higher.
The high level of fixed-income market volatility reflects the less certain outlook for interest rates. Fed funds rate expectations have been rising steadily as markets anticipate the start of a new rate rising cycle, but whether it will begin in June or September 2022 is unclear. The expected rate at the end of the cycle has varied by nearly 100bp over the course of the year. The Fed’s own forecasts are unusually wide, with estimates of the rate in 2024 ranging from 0.625% to 2.625%.
The uncertain policy rate outlook reflects, in turn, the uncertain path of inflation. Not only has the headline consumer price index (CPI) surpassed consensus estimates eight times this year, the amount of the surprises over the last year are well above average.
The uncertainty over inflation should not be surprising as one could hardly forecast the impact of trillions of dollars of fiscal stimulus on an economy that was shut for several months of the year. In addition, the pandemic has led to significant changes in the attitude of workers, adding labour market uncertainty to the mix.
The risk for equities would come from a further acceleration in the inflation rate, medium-term inflation expectations rising above their long-run averages, and the Fed coming under pressure to accelerate its tapering programme and raise interest rates sooner, and by more, than currently anticipated.
A history lesson
Despite the unprecedented pandemic and the authorities’ response to it, we have looked for historical parallels to help us anticipate what might occur.
A blog post by the US Council of Economic Advisers suggests the inflationary episode from 1946-48 was a more appropriate comparison period than the 1970s, as the post-war period was characterised by supply shortages colliding with newly released pent-up demand. The inflation was transitory, however, and after peaking at nearly 20% in March 1947, the CPI rate had turned negative by May 1949. As Paul Krugman has pointed out, however, the Fed’s response to the high inflation ultimately provoked a recession.
How did US equities do during that period? Investors generally view equities as one of the better hedges against inflation. That has proved to be the case so far this year. Since US CPI accelerated to above 2% in March, the S&P 500 has gained 23%. The experience from 1946-48 was rather different.
To curb stock market speculation, regulators increased margin requirements in January 1946 from 75% to 100%. Many investors were forced to sell their shares to meet the requirements, which contributed to a more than 20% decline in the market (see Exhibit 2). 
By the time inflation had fallen back to 3%, the S&P 500 was 9% higher than the low of February 1948, but still 21% below the peak in May 1946. The most resistant sector was energy, which dropped by just 2% from May 1946 to February 1948, followed by technology (at the time, consisting of computer hardware). The worst performing sectors were healthcare and industrials.
This year, the top sectors have been real estate, information technology and consumer discretionary; the worst, consumer staples and utilities. So even if the outlook for inflation resembles that of the late 1940s, there appear to be few lessons for the markets.