There is little doubt that ultra-low interest rates and abundant central bank liquidity have played a key role in driving financial markets in recent years. As a result, it comes as little surprise that increasingly hawkish noises out of the US Federal Reserve – the world’s most influential central bank – have given investors a bout of the jitters in recent weeks.
With the labour market tightening and inflation at a multi-decade high, Fed policymakers have signaled an intention to withdraw monetary stimulus earlier and faster than previously expected. At its December meeting, the Fed indicated that the termination of its quantitative easing (QE, or buying bonds) programme would be brought forward by three months to March 2022. In addition, policymakers’ economic projections flagged an intention to raise interest rates three times in 2022, having previously forecast only an evens chance of just one 25 basis point rate hike1. Furthermore, the minutes of the December meeting revealed that policymakers had discussed the idea of reducing the Fed’s balance sheet (by not reinvesting the proceeds of bonds as they mature), possibly soon after the first increase in interest rates2.
If we do see both Fed rate hikes and a reduction in the balance sheet in 2022 it will mark a swift turnaround on the policy front. By way of comparison, during the last Fed tightening cycle, there was a gap of three years between the Fed ending QE-3 (the Fed’s third phase of QE) in October 2014 and initiating a reduction in its balance sheet (i.e., quantitative tightening or QT) in October 20173.
A disruptive tightening?
The key question for investors is how disruptive the coming monetary tightening will be. As it stands, the Fed’s projections do not suggest that policy is going to move into restrictive territory anytime soon. Policymakers’ median forecast sees the Fed’s key interest rate rising to 0.9% by the end of 2022 and core inflation falling to 2.7%, a combination which gives a real (i.e., inflation-adjusted) policy rate of minus 1.8%4. Indeed, on this basis, the policy rate – which the Fed’s latest median forecast sees rising to 2.1% in 2024 – does not turn positive during the 3-year forecast horizon. With real rates this low, there would appear to be little risk of Fed tightening pushing the economy into recession; JP Morgan calculations indicate that the real Fed Funds rate typically rises above 2% prior to an economic downturn 5.
However, given that the Fed is becoming progressively more hawkish, and inflation pressures are broadening, this reading could start to look complacent. One Fed official, Christopher Waller, has floated the possibility of 4 or 5 rate hikes this year 6. Moreover, the minutes of the December meeting suggested that the Fed’s balance sheet could actively be used to raise long-term interest rates, with the run-down in bond holdings occurring at a faster pace than during the 2017-19 period of QT 7.
This provides a signal that the Fed thinks that higher longer-term bond yields, in addition to a rise in its policy rate, will be needed to bring inflation under control. This makes sense given that mortgage rates and corporate borrowing costs are influenced more by long-term yields than short-term rates, and are historically low, if not negative, in real (i.e., inflation-adjusted) terms. The markets have got the message. The yield on the 10-year US Treasury bond has risen by around 40 basis points since mid-December to 1.8% 9, but probably has further to go.
Of course, the Fed’s balance sheet is not the only factor that influences bond yields. Expectations for both growth and inflation, as well as demand for safe assets obviously play a key role. However, with the Fed now holding over US$8 trillion of bonds 10, it would be a brave trader that would bet against higher yields if the Fed deems them necessary.
Against this backdrop it is not surprising that the consensus view is that 2022 will be another difficult year for bond investors; higher bond yields imply capital losses on fixed income securities.
Equity market impact
The more challenging question is what Fed tightening means for equity markets. Looking at previous rate hike cycles, analysts are keen to point out that equity markets tend to push higher during the year after the first rate hike. This is because the monetary authorities will be withdrawing stimulus in part because economic growth is strong, which in turn translates into rising profits. During the last four rate-hike cycles, the US equity market (as measured by the index of the 500 largest companies) has gained an average 7.7% during the 12 months after the first rate increase, according to figures from Factset10.
However, there are valid concerns that equities could be more vulnerable during the coming tightening cycle. For a start, growth in the global economy, and by extension profits growth is likely to slow this year (see our commentary of December 2021). Global corporate earnings rose by around 50% last year as activity bounced back from the pandemic-stricken lows of 2020, but consensus points to a more modest rise of about 7% in 2022 11.
Moreover, the valuations investors place on equities is now considerably higher than the last time the Fed started raising interest rates. The forward price/earnings (p/e) multiple on US equities is currently around 21 compared with roughly 16 in December 2015 when the Fed’s last rate hike cycle began 12. In a related development, the weighting of growth-oriented companies, most notably in the tech sector (e.g., Apple, Amazon, Microsoft etc.), has increased in recent years 13, with the result that movements in the share prices of these highly-valued companies play an outsized role in driving the broad market. This is important as these growth/tech stocks tend to be more sensitive to rising bond yields, as a higher discount rate on earnings in the distant future results in a lower present value today.
Given that there has been a strong positive correlation between growth in the Fed’s balance sheet and the run-up in US equities during the last 20 months or so14, there is understandable concern that a reduction in central bank bond holdings and a withdrawal of liquidity will weigh on US equities once quantitative tightening starts. After all, part of the rationale for quantitative easing was to lift asset prices and so boost demand via so-called wealth effects. Central bank purchases of government bonds reduced yields, enabling companies to issue debt cheaply, which in some cases was used to fund share buybacks (an important source of equity demand in recent years).
However, correlation does not necessarily mean causation, and it is too simplistic to suggest that a reduction in the Fed’s balance sheet will automatically result in a decline in the broad equity market. Indeed, during the last episode of Fed quantitative tightening, between October 2017 and July 2019, US equities notched up a gain of around 17%, albeit with some serious bouts of volatility, most notably during the final quarter of 2018 when the market fell nearly 14%15.
Increased volatility
Indeed, if there is one forecast that analysts agree on for 2022, it is that equity market volatility is likely to increase as central banks withdraw stimulus. However, the extent to which markets would have to fall in order to prompt a dovish pivot in Fed policy – such as that which ushered in a strong market rebound in 2019 – remains an open question.
How equities ultimately perform over the next year will depend on the extent to which headwinds to valuations from rising rates/yields are offset by the tailwind of higher earnings. There are obviously uncertainties on both these fronts, but at least the equity market holds out the possibility of long-term, inflation-beating returns, which cannot be said of most of the developed market bond universe. While increases in wages and input costs carry the potential to squeeze profit margins from their near record highs 16, pricing power has been strong of late, with companies generally succeeding in passing cost increases onto customers. This suggests the asset class continues to provide a hedge against inflation.
It is likely that bond yields have further to rise before asset allocators see them as an attractive alternative to equities. One survey has suggested that global fund managers would need to see a yield of 2.5% on the US 10-year bond to tempt them 17.
Sector rotation
An environment of rising bond yields will have implications for equity sector performance. As noted earlier, highly-valued, growth-oriented stocks tend to struggle as bond yields increase. In contrast, sectors such as energy and financials tend to outperform 18. In particular, banks benefit as their net interest margins increase. In turn, sector trends play a big role in determining relative geographic market performance. In recent weeks, returns from the lowly-valued UK equity market (which has a relatively high weighting of financial and energy companies) have beaten their US large cap counterparts (which have a particularly high weighting to tech) 19. It is early days yet and there is a high degree of uncertainty, but this has raised hopes that UK equities are well-placed for a long-overdue period of outperformance in 2022.
18th January 2022
1. https://uk.finance.yahoo.com/news/fed-fomc-monetary-policy-decision-december-2021-153342164.html
2. https://www.federalreserve.gov/monetarypolicy/fomcminutes20211215.htm
3. https://www.yardeni.com/chronology-of-feds-quantitative-easing/
4.https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20211215.pdf
5. JP Morgan Equity Strategy; January Chartbook.
6. https://www.reuters.com/world/us/feds-brainard-nods-march-rate-hike-calls-action-grow-2022-01-13/
7.https://www.federalreserve.gov/monetarypolicy/fomcminutes20211215.htm
8. https://uk.investing.com/rates-bonds/u.s.-10-year-bond-yield
9. https://fred.stlouisfed.org/series/WSHOSHO
11. https://www.yardeni.com/pub/performancemsciearningsrevenues.pdf
13. https://www.yardeni.com/pub/faangms.pdf
14. https://fred.stlouisfed.org/graph/?graph_id=980301
15. https://fred.stlouisfed.org/graph/?graph_id=980310
16. https://insight.factset.com/sp-500-is-reporting-third-highest-net-profit-margin-since-2008-for-q3
18. JP Morgan Equity Strategy, 10th January 2022
19. FE Analytics