August 27, 1998
The Task at Hand

Inflation and Market Moves
By Randy Befumo
(From the 07/05/96 Evening News)

POINT: Why Inflation Causes Market Moves

Shifts in "asset allocation" can really put a hurting on fragile indicies. Didn't understand a word of that last sentence? Fret not, Fool... by the end of this little squib you will be able to dazzle your friends and neighbors when they come giggling or weeping after checking their mutual fund quotes.

If there ever appears to be a danger of inflation heating up, there will always be talk of the Federal Reserve hiking interest rates at the next meeting of the Federal Open Market Committee (FOMC). The rates the Fed would hike would be the Federal Funds Rate, which is the rate at which it lends money to banks, and the Discount Rate, which is the rate at which the Fed says banks can lend money to each other. By hiking these rates, the Fed would decrease the money supply by making it more expensive to borrow money. Decreasing the money would hopefully stave off inflation, the Fed's main preoccupation.

The reason why stocks get smashed when the Fed pre-emptively moves to stave off inflation is because of the massive money controlled by relatively conservative pension funds, insurance companies and other global asset allocators. These are the guys that are constantly measuring the "riskless rate" of return possible in bonds versus the potential in stocks and who "allocate" their "assets" accordingly, effectively divvying their money between one or the other.

Small shifts in their asset allocations when bonds get more attractive mean big swings in the stock market as money goes pouring out. As much of this money tends to be concentrated in the bluest of blue chips, the S&P 500 and the Dow suffer the worst when the big money is shifting toward bonds or away from bonds. In the reverse, if some report indicates inflation is not not a present worry, then investors will often be treated to spectacular surges in the market indexes as large asset allocators sell bonds and buy stocks.