Rate Jitters Sink Stocks, Bonds as 2022 Dawns. What’s Different This Time.

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With a 3.9% unemployment rate and some people reluctant to rejoin the workforce, firms are pushing to find workers.

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Luke Sharrett / Businesshala

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It’s a new year, but last year’s problems—inflation and the Federal Reserve’s delayed policy response to slow it—are battering stocks and bonds alike.

Treasury yields rose last week, ending the benchmark 10-year at 1.77%, the highest point since last March. Short-term Treasury rates hit postpandemic highs as markets adjusted the central bank’s key policy rate by the end of 2022 with a possibility of three, and perhaps four.

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Perhaps most importantly, the Fed will not only discontinue purchases of its securities, which have pumped trillions of dollars into the financial system, as previously announced. But minutes from the policy-making Federal Open Market Committee’s December meeting released last week, and comments from Fed officials, also raised the possibility that the central bank would actually begin to reduce its holdings, thereby eroding liquidity. Will go and get tough. financial terms.

That prospect sent shivering through riskier markets, especially technology and highly valued growth stocks. Redeeming the distant cash flow at a higher rate mathematically translates to a lower present value of that stream. In contrast, financial stocks, which benefit from higher interest rates, were relative winners, as well as cyclicals that deliver strong earnings growth in an economy that is expanding at a double-digit nominal rate, with the effect of accelerating growth. Prices included.

That means the Fed has achieved one of its mandates: to drive inflation above its long-term 2% target, to make up for past shortfalls. And once its December jobs report is released on Friday, it could arguably declare “mission accomplished” on its employment mandate.

While non-farm wage growth came to light for the second month in a row at 199,000 (less than half of the 424,000 forecast), the headline unemployment rate fell sharply to 3.9%, from 4.2% in November and 4.6% in October. This puts the unemployment rate just above the 3.5% trough it reached in February 2020, just before COVID-19, and below the 4% that the FOMC estimates its long-run equilibrium unemployment rate according to its most recent . summary of economic projections, Released last month.

Evidence of the recovery of the labor market is 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 at a 6% annual clip, “the best in decades outside of Covid data noise in April/May 2020,” writes Peter Bokvar, chief investment strategist at Blakely Advisory Group. customer note.

However, those pay benefits are not in line with the prices. When the December figures are reported this coming week, the consumer price index is likely to rise at a rate of over 7% year-on-year.

According to Evercore ISI, inflation is likely to remain high for five reasons. Those pay benefits will probably accelerate; Same for rent. Corporations also have “unprecedented” pricing power. And there is “greenflation,” it adds. Just as air and water pollution drove inflation in the 1970s, climate change is likely to be addressed this decade, according to the firm’s Friday economic note.

But the bigger reason is monetary incentives. Evercore ISI estimates that the US M2 money supply has increased by an astonishing 41% over the past two years. This is more than twice the pace of monetary expansion since the 2008-09 financial crisis and inflation is much higher than the currency printing of the 1970s.

The Fed’s policy pivot appears relatively light in the face of those inflationary forces. Its federal-funds target rate remains above zero for nearly two years before the crisis. And if there were a three quarter-percentage-point increase to 0.75-1% by the end of the year, that would still leave the real federal-funds rate deep in negative territory, even when measured against the Fed’s very optimistic projection that its The preferred inflation measure (the personal consumption expenditure deflator, which always runs cooler than the CPI) will fall to 2.6% by the end of this year.

Still, the new Fed tightening likely conjures up unpleasant memories of late 2018, when rate hikes and balance-sheet cuts pushed the S&P 500 index slightly below the 20% bear-market norm. What was different was that the fed-funds rate, then 2.40%, was well above inflation and therefore positive in real terms, about 0.5 percent above the CPI’s 1.9%.

Long-term rates also moved above inflation, with the 10-year Treasury at around 3.25% – a positive 1.35% in real terms. The current 1.77% is deeply negative in real terms, compared to the 7% CPI. The 10-year Treasury inflation-protected security, which is considered to be priced at projected inflation over the coming decade, ended the week at minus 0.77%.

Read more above and below Wall Street: Top Rated Bond ‘Make No Sense’. With 63 years on the market, Dan Fuss should know.

But perhaps the real market news is that a less accommodating Fed likely lifted real interest rates, which in turn broke riskier assets. 10-year TIPS yields were up 23 basis points in the week, while five-year TIPS yields rose 28 basis points to minus 1.33 per cent. (One basis point is 1/100th of a percentage point.)

Not surprisingly, the riskier asset faced, with the Nasdaq 100’s largest non-financial stocks falling 4.5% in the week, their worst performance since last February. The rise in real rates, though still at negative levels, was enough to push down financial asset prices. The question is whether negative real rates will provide the restraint to contain inflation, as the Fed expects.

Write Randall W. Forsyth at [email protected]

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