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Why Do Financial Markets Fall After Inflation Rises?

The Standard & Poor’s 500, Nasdaq, and Dow Jones indexes declined between 3.5% and 5%, when investors sold their positions due to “fear of inflation”

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The financial markets had their worst fall since October 2020 with the announcement of the inflation rise by the Bureau of Labor Statistics. Although the news of an annual inflation rise to 4.2% reaffirmed the fall of the stock markets, the decline of the main financial indexes had been coming for three days, in anticipation of the fateful announcement.

The Standard & Poor’s 500, Nasdaq, and Dow Jones indexes declined between 3.5% and 5%, when investors sold their positions due to “fear of inflation”, as explained by Edgar Fernandez, Investment Banker at Liceo Capital Advisors, who spoke to El American. In this sense, Fernandez said that “inflation is accelerating and the markets are discounting future interest rate hikes.”

“If interest rates rise, the yield of public debt will increase, which will cause the stock market to fall because investors will demand a higher yield from the stock market since the risk-free yield (government debt) will be higher”, continued Fernández regarding the growth of the US Treasury Yield.

inflation rise - financial markets - el american
The inflation rise put markets on alert of what might be a costly business environment in America. (EFE)

The increase in Treasury yields indicates that the markets perceive greater risk in U.S. debt and require a higher interest rate to continue disbursing money to the U.S. bond market.

The inflation rise may not be transitory

While the Federal Reserve (Fed) may choose to raise interest rates to control inflation, this would send interest rates on U.S. government and corporate debt soaring to record highs. “Many companies that have hyper-indebted themselves over the last decade would suffer greatly from a rise in interest rates,” explains Fernandez.

For Fernandez “the FED may be forced to stop buying assets which will diminish the excess liquidity currently in the market that has caused stock markets to soar to bubble levels”, however, he clarifies that this scenario is only a possibility within the framework of FED actions.

Investor and economics professor Nouriel Roubini stated that under the current situation the U.S. and developed countries could be mired in higher inflation in the future.

“If inflation fears continue to permeate investors we will see more days of rising Treasury Yields and falling stock markets,” Fernández asserted.

Bullish crypto markets

Cryptocurrencies were also affected by the increase in inflation in the United States, with Bitcoin being one of the cryptoassets that fell the most, dropping 7% during the day on Tuesday and settling again at $50,000.

Ethereum’s drop was even steeper than Bitcoin’s with an 8.5 % contraction on Wednesday. Ehtereum had been trading at nearly $5,000 before falling to $3,700 during the current stock market run.

inflation rise - El American
Cryptocurrencies were also affected by the inflation rise (EFE)

For Fernandez this shows that cryptocurrencies are still a speculative asset and not a store of value: “cryptos are not a store of value and are more correlated with the stock market than with inflation.”

The question now is, can cryptos become a store of value? The answer for the banker is “yes, but now they have had the opportunity to prove it and they have failed miserably” and he also said that “any investment in cryptos is purely speculative and has no fundamentals behind it [i.e. assets backing its value] for now.”

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