It’s a law of physics: when two forces collide, momentum is lost. Investor optimism over economic growth, which has fueled a market rally, is running headlong into the reality of rising interest rates.

Robust economic growth is stoking inflation fears, which in turn is lifting bond yields. Rising yields are rattling Wall Street, as reflected by today’s stock market swoon.

However, financial services closed higher and posted the biggest gains among the major sectors, as bank investors relished the prospect of higher profits from a wider rate differential.

Technology stocks led losers as large caps coughed up their recent run-up, with bellwether Apple (NSDQ: AAPL) falling 1.76%. The CBOE Volatility Index (VIX) jumped a whopping 21.79%.

The U.S. Labor Department reported this morning that initial claims for state unemployment benefits fell 8,000 to a seasonally adjusted 207,000 for the week ended September 29, near a 49-year low.

In a separate report today, the U.S. Commerce Department said new orders for U.S.-made factory goods in August recorded their biggest increase in nearly a year.

Investors started to bite their nails. Is the economy overheating?

The 10-year Treasury note yield hit its highest level since 2011; the 30-year bond yield breached its highest level since 2014. Bond prices move in the opposite direction of yields.

Higher bond yields boost borrowing costs; economic growth and corporate profitability suffer. Higher yields also render bonds a more attractive alternative to riskier stocks and they make excessive equity valuations harder to justify.

Bond funds under pressure…

A reader recently asked me about rising interest rates and how they affect bond mutual funds. In this case, the situation is a bit complicated, because bond fund portfolios can be diverse.

Generally speaking, bond funds typically perform well when interest rates are falling because the fund’s holdings probably carry higher coupon rates than newly issued bonds, and consequently rise in value. However, if the Federal Reserve is hiking rates as it is now, bond funds could get hit because new bonds with higher coupon rates drive down the value of older bonds.

This rule applies, at least, in the short term. Keep in mind, the value of a mutual fund is calculated by its net asset value (NAV), which is the total market value of its entire portfolio divided (including interest or dividends earned) by the number of shares outstanding.

The NAV is partly determined by the market value of the fund’s assets, which means rising interest rates can significantly affect the NAV of a bond fund holding newly acquired assets that have become less desirable.

If interest rates fall and older bonds start trading at a premium, the NAV could greatly increase. For investors seeking to cash out mutual fund shares over the short term, the changing direction of interest rates can be either a disadvantage or a boon.

For fixed-income assets in the third quarter and year-to-date, rising rates were a distinct disadvantage. The following chart depicts the performance of major bond categories, based on their benchmark exchange-traded funds (ETFs):

Source: Bloomberg

Tariffs equal taxes…

It’s almost certain that the Fed will hike rates in December and the central bank will continue tightening the monetary spigot throughout 2019.

As I’ve made clear in recent issues of Mind Over Markets, I believe that investors have grown complacent about inflation, which poses a greater risk than many think. Today’s market rout gave us a taste of that risk.

The trade war, in particular, is adding inflationary pressures. Tariffs are, after all, a form of taxation that raises input costs. Wall Street is underestimating these pressures.

The investment herd has displayed unwarranted optimism whenever there’s an ostensible resolution of a trade battle. You should ignore the photo-ops and disingenuous press releases.

Many tariffs are in place and they’re already producing a cumulative inflationary effect. This effect started slowly and quietly at first, but it’s growing faster and more forceful as time wears on, sort of like the crescendo in a bolero.

Inflation shrinks the real rate of return on investments. If an investment earned 7% over a 12-month period and inflation averaged 1.5% over that time, the investment’s real rate of return would have been 5.5%.

You need to buy inflation hedges now, before the rest of the crowd realizes the magnitude of the threat and bids up the prices of these assets. Broadly speaking, inflation hedges worth considering include precious metals, inflation-indexed bonds, and agricultural commodities.

Unemployment hovers at 3.9%, a 17-year low. As the job market tightens, employee wages could spike higher at any moment, triggering an inflation panic that could prompt the Fed to tighten more aggressively than planned, which in turn could trigger a full-blown correction.

Thursday Market Wrap

• DJIA: 26,627.48 -200.91 (0.75%)
  
• S&P 500: 2,901.61 -23.90 (0.82%)
  
• Nasdaq: 7,879.51 -145.57 (1.81%)
  

Thursday’s Big Gainers

• Investment Technology Group (NYSE: ITG) +25.29%

Tech hedge fund targeted for buyout by high-speed trader.

• Barnes & Noble (NYSE: BKS) +21.79%

Bookseller announces it would welcome a buyout.

• Cloudera (NYSE: CLDR) +11.53%

Cloud services provider announces merger with peer.

Thursday’s Big Decliners

• vTv Therapeutics (NSDQ: VTVT) -21.76%

Investors wary as insider buying spikes at drug maker.

• Arrowhead Pharmaceuticals (NSDQ: ARWR) -17.40%

Wall Street looks askance at biotech’s gene-splicing therapy deal with bigger rival.

• Trevena (NSDQ: TRVN) -11.82%

Biotech’s new painkiller underwhelms analysts.

Letters to the Editor

“Do you think Britain will hold a second referendum on Brexit?” — Kathy L.

As the “leave” camp learns more about the actual ramifications of Britain leaving the European Union, such as its harm to the country’s economy, greater numbers of them are expressing buyer’s remorse. But British Prime Minister Theresa May insisted this week that a do-over won’t happen.

Questions about overseas economic trends? Send me an email: mailbag@investingdaily.com

John Persinos is the managing editor of Investing Daily.