Inflation is the next big fear for the stock market

NEW YORK - The inflation boogeyman has reared its ugly head and sent U.S. stock investors racing for the hills in recent days.

This week, coming off one of the most volatile stretches in years, two important readings on U.S. inflation could help determine whether the stock market begins to settle or if another bout of volatility is in store. If January's U.S. consumer price index, due Wednesday from the U.S. Labor Department, and the producer price index the next day come in higher than the market anticipates, brace for more selling and gyrations for stocks.

U.S. consumer prices rose 2.1 percent year-on-year in December and are forecast to stay around that pace this month.

"If we get a hot CPI print it will insert additional uncertainty. But if we get a quiet, below-consensus print, you may see yields down and equities rally," said Jason Ware, Chief Investment Officer & Chief Economist at Albion Financial Group in Salt Lake City.

The stock market has become highly sensitive to inflation this month. A sell-off in U.S. stocks was in large part triggered by the Feb. 2 monthly U.S. employment report, which showed the largest year-on-year increase in average hourly earnings since June 2009.

Recent U.S. tax cuts that may spur economic growth, the prospect of more government borrowing to fund a widening fiscal deficit and rising wages have all pushed some benchmark interest rates to near four-year highs.

The jump in wage inflation pushed yields on the benchmark 10-year U.S. Treasury note closer to the 3 percent mark last seen four years ago, denting the attractiveness of stocks, and unnerving investors who fear that inflation will force the U.S. Federal Reserve to raise short-term interest rates at a faster pace than is currently priced into the market.

On Thursday, New York Federal Reserve President William Dudley said the central bank's forecast of three rate hikes still seemed a "very reasonable projection" but added there was a potential for more, should the economy look stronger.

Traders are currently putting the chances of a quarter-point hike by the Fed at its March meeting at 84.5 percent, according to Thomson Reuters data.

While many analysts were predicting bond yields to rise this year as global economies improve, the suddenness of the move was a large factor in the recent stock market sell-off.

"The pace really does matter," said Ron Temple, head of US Equities and co-head of Multi-Asset Investing at Lazard Asset Management in New York.

"If we see 3.0 percent [this] week, that is going to spook people more — the equity market psyche is fragile at this point."

While volatility has subsided a little from the heights touched last week, it is far from an all clear, Nigol Koulajian, chief executive of Quest Partners, a New York-based systematic commodity trading adviser with $1.4 billion in assets under management, said.

Koulajian pointed to the bond market as the main catalyst right now for near-term moves in the stock market.

"Investors need to keep a very, very close eye on fixed income," he said. "The catalyst needn't be big."

But analysts also caution yields are not at levels that should be alarming to investors, and in fact are at levels that signal a healthier global economy. The performance of some stocks this week points to a belief the consumer is also getting healthier.

The average yield on the 10-year Treasury note over the past 30 years is 4.834 percent, still well above current levels.