It has been an inauspicious start to 2022 for financial markets, with a sharp sell-off in sharemarkets and an equally abrupt spike in bond yields creating an ominous tone for markets that have generally had a very, very good pandemic.
The explanation for last week’s sudden turbulence is straightforward and lies, as it often does, within the US Federal Reserve Board.
It was the release last week of the minutes of the Fed’s December Open Market Committee meeting that shook the markets, sending equities tumbling and bond yields surging to pre-pandemic highs.
It wasn’t so much the confirmation that most of the members of the committee (which sets monetary policy for the world’s most powerful and influential central bank) anticipate three 25 basis point rate rises in the federal funds rate this year. That’s in line with market expectations.
Rather, it was the disclosure that the members had seriously discussed shrinking the Fed’s balance sheet quite soon after the start of the rate rises. That was unexpected.
In response to the pandemic the Fed launched a new bout of quantitative easing – buying bonds and mortgages to inject liquidity into the US and global financial system and to keep interest rates at negligible levels. It has more than doubled the size of its balance sheet over the past two years, from $US4.2 trillion ($5.9 trillion) to $US8.8 trillion.
While it has been shrinking the size of its asset purchases since November and expects to cease the buying completely by March, there was an expectation that the Fed would do as it did in the aftermath of the 2008 financial crisis and keep reinvesting the proceeds from maturing securities.
It took nearly a decade after the financial crisis for the Fed to start shrinking its balance sheet, a process it aborted less than two years later in the face of market tantrums.
Thus the suggestion that the biggest buyer of Treasury securities might start withdrawing from the market relatively soon, withdrawing liquidity from the system and creating another source of upward pressure on interest rates in the process, rattled investors.
The US market slumped 2.4 per cent after the minutes were released and bond yields rose. The 10-year bond yield, which started this year at 1.51 per cent, is now 1.76 per cent after briefly hitting 1.8 per cent on Friday, a level last seen in February 2020 before the severity of the threat of the pandemic was widely recognised.
The Fed’s conversion late last year from inflation complacency (it was supposed to be “transitory”) to inflation concern is driving its suddenly more “hawkish” expectations for interest rates and quantitative tightening.
In the year to December the US inflation rate was 6.8 per cent, its highest level for 30 years. On Wednesday the data for the month of December will be released in the US and is expected to show an inflation rate above 7 per cent, which would be its highest rate since 1982.
The continuing global and domestic supply chain bottlenecks, rising producer and wage inflation in a tight labour market characterised (as it is here) by labour shortages, high energy prices and rising housing and rental costs appear to be entrenching inflationary pressures, hence the Fed’s decision to “retire” the word “transitory” from its lexicon.
An inflation rate above 7 per cent this week would add to the markets’ conviction that US rates are likely to rise harder and faster than previously anticipated and that the Fed will embark on quantitative tightening earlier and more aggressively than even last week’s minutes might suggest.
That would be bad news for stocks, particularly the high-multiple technology stocks.
The tech-laden Nasdaq market has fallen about 5.7 per cent in a week and the mega-tech FANG index (Facebook, Apple, Amazon etc) 4.9 per cent as investors substituted higher discount rates for the near-zero risk-free rates used to discount the future cash flows of a sector seen to have strong long-term growth prospects.
Conversely, the Dow Jones, populated by old-fashioned “value” stocks, suffered only a 1.5 per cent decline as investors rotated away from the stocks regarded as the most aggressively priced (and therefore the riskiest in a rising rate environment) to more defensive companies.
The Fed, which misjudged the trajectory and duration of inflation last year and consequently missed the opportunity to dampen the surge before it became engrained, might, of course, get it wrong — in either direction – this year.
While there are some signs that the global supply chain blockages are easing, there are some elements of those chains that appear to have been broken by the pandemic and the awareness of domestic vulnerabilities it has exposed to governments and companies. Heightened geopolitical tensions are also forcing some changes to pre-pandemic supply lines.
An inflation rate above 7 per cent this week would add to the markets’ conviction that US rates are likely to rise harder and faster than previously anticipated.
Developments in labour markets in western economies – the shortages of labour and wage inflation – may or may not reflect temporary, pandemic-related effects but they have rekindled wage inflation for the first time in a couple of decades, which will spill over (along with the supply chain-driven product shortages) into producer prices.
If the Fed and other key central banks become convinced that there are structural strands within the elevated inflation rates their economies are now experiencing they will have no option but to go harder in their efforts to bring them under control.
Alternatively, of course, if the supply chains are untangled, the pandemic becomes less disruptive and participation rates in labour markets improve, inflation might subside more quickly than the central banks now appear to envisage.
Central banks’ timing is rarely perfect, or even close to it – they always seem to be behind the developments in their real economies and today’s environment is as complex and uncertain as it has ever been – so the potential for misjudgments with material consequences for economies and financial markets is very real.
The past two years have been tremendous for risk-taking investors but, with the central bank safety nets of ultra-low interest rates and virtually unlimited liquidity now being withdrawn, the outlook for this year is now far more uncertain and likely far more volatile as the banks grapple with an unpredictable threat, inflation, that they haven’t seen for decades.
Source: Thanks smh.com