Evaluate Jitters’ stocks and bonds as we head into 2022. Which is different this time around.
It’s a new year, but last year’s problems – inflation and the Federal Reserve’s belated policy response to slow it down – are hitting stocks and bonds alike.
Treasury yields surged last week, with the 10-year benchmark ending at 1.77%, matching the peak it reached last March. Short-term Treasury rates hit post-pandemic highs as the market adjusted for the possibility of three or even four central bank rate hikes by the end of 2022.
Perhaps more importantly, the Fed is not just going to cut back on its purchases of securities, which have injected trillions of dollars into the financial system, as previously announced. But the minutes of the federal open market policy-making committee’s December meeting released last week, and comments from Fed officials, also increased the chances that the central bank would actually start cutting back. its holdings, which would tend to drain liquidity and tighten financial conditions.
This prospect has thrilled risky markets, especially technology and highly valued growth stocks. Discounting remote cash flows at a higher rate mathematically results in a lower present value of that flow. In contrast, financial stocks, which tend to benefit from higher interest rates, have been relative winners, as have cyclical stocks looking to generate strong earnings growth in an economy that grows at a nominal rate. double digit, which includes the effect of rapidly rising prices.
This means that the Fed has fulfilled one of its mandates: to get inflation to exceed its long-term target of 2%, to offset previous deficits. And after the publication of the December employment report on Friday, he could arguably declare “mission accomplished” on his employment mandate.
While the increase in the non-farm wage bill appeared for the second consecutive month to 199,000 (less than half of the expected 424,000), the overall unemployment rate fell sharply to 3.9% from 4.2 % in November and 4.6% in October. This places the unemployment rate just above the low of 3.5% reached in February 2020, just before the outbreak of Covid-19, and below the 4% that the FOMC estimates to be the equilibrium unemployment rate. long-term, according to its most recent summary of Economic Projections, released last month.
The proof of the healing of the labor market lies in rising wages. Average hourly and weekly earnings are up 4.7% from their levels a year ago. Over the past six months, average hourly earnings have grown 6% per year, “the best in decades outside of Covid data noise in April / May 2020,” writes Peter Boockvar, chief investment strategist at Bleakley Advisory Group, in a client note.
However, these wage gains do not follow the prices. The Consumer Price Index is expected to hit an annual rate of over 7% when December data is released next week.
Inflation is expected to remain high for five reasons, according to Evercore ISI. These wage gains are likely to accelerate; ditto for the rents. Businesses also have “unprecedented” pricing power. And there is “greenflation”, he adds. Just as tackling air and water pollution raised inflation in the 1970s, so should the fight against climate change this decade, according to Friday’s economic note from the company.
But the main reason is the monetary stimulus. Evercore ISI calculates that the US M2 money supply has grown by 41% over the past two years. This is more than double the pace of monetary expansion following the 2008-09 financial crisis and significantly higher than the inflationary 1970s money printing.
The Fed’s policy pivot appears relatively subdued in the face of these inflationary forces. Its target federal funds rate remains just above zero almost two years after the crisis. And if there were three-quarter percentage point hikes by the end of the year, to 0.75-1%, that would still leave the real federal funds rate in negative territory, even relative to the Fed’s very optimistic projection that its preferred measure of inflation (the personal consumption expenditure deflator, which is invariably colder than the CPI) will fall to 2.6% by the end of this year.
Nonetheless, the prospect of further Fed tightening brings up unpleasant memories of late 2018, when rate hikes and balance sheet cuts sent the
S&P 500 Index
tumbling just below the 20% bear market benchmark. What was different was that the federal funds rate, then 2.40%, was well above inflation and therefore positive in real terms, around 0.5 percentage point above 1.9. % of CPI.
Long-term rates were also higher than inflation, with the 10-year Treasury peaking at around 3.25%, or 1.35% in real terms. Compared to a CPI of 7%, the current 1.77% is deeply negative in real terms. The inflation-protected 10-year Treasury note, which is supposed to be priced against expected inflation over the next decade, ended the week at minus 0.77%.
Read more From top to bottom of Wall Street: The highest rated bonds “Make no sense”. With 63 years in the market, Dan Fuss should know.
But maybe the real news from the market is that the prospect of a less accommodating Fed pushed real interest rates up, which in turn weighed on risky assets. The 10-year TIPS yield rose 23 basis points on the week, while the five-year TIPS yield rose 28 basis points, to minus 1.33%. (One basis point is equal to 1 / 100th of a percentage point.)
Unsurprisingly, risk assets suffered as the Nasdaq 100 of the largest non-financial stocks slumped 4.5% on the week, its worst performance since last February. The rise in real rates, although at still negative levels, was enough to weigh on the prices of financial assets. The question is whether negative real rates will help curb the fall in inflation, as the Fed expects.
Write to Randall W. Forsyth at [email protected]