In early March last year, the first signs of the spread of the new crown pneumonia epidemic in the United States emerged. To prevent a recession, the Federal Reserve offered all the tools it had during the financial crisis within a month and created a number of targeted liquidity support tools. Asset prices were the first to respond, and as the anchor of global risk asset pricing, the U.S. Treasury yield curve sank across the board, with the 10-year U.S. Treasury yield once as low as 0.5%. Zero interest rates and unlimited easing helped U.S. stocks achieve a V-shaped rally. At that time, the economic fundamentals were still in the quagmire of the crisis, and the capital markets were not yet worried about the policy exit. Now, the economic recovery to form a unanimous expectation, inflationary pressure is expected to rise significantly, the policy exit is expected to have been put on the table. The Fed began to consider how to communicate with the market in balancing economic recovery, financial stability and the direction of monetary policy.
U.S. bond yields spike triggered a sharp market shock
After the Federal Open Market Committee (FOMC) meeting on March 17 this year, Federal Reserve Chairman Jerome Powell again shouted to the market: short-lived inflationary pressure and high unemployment rate will allow monetary policy to continue to maintain an accommodative state; there is still a long time to cut the asset purchase program; will continue to pay attention to the rise in U.S. Treasury yields.
Powell’s words “dovish” can not hide the FOMC members gradually inclined to raise interest rates. The “dot plot” shows that the 18 members of the FOMC, four people hope to raise interest rates in 2022, compared with only one person at the meeting last December; seven people believe that in 2023, compared with only five people in December last year. Next day (March 18), after the market digested the information, the Nasdaq fell 3.02% and the 10-year U.S. Treasury yield rose to 1.71%.
Since this year, the 10-year U.S. Treasury yield has been rising at a faster pace month by month, rising above 1.1% at the end of January and to 1.44% at the end of February. By March 19, it had risen 80 basis points from the end of the previous year. As U.S. Treasury yields accelerated upward, supported by good news such as vaccinations and fiscal stimulus, the market style took on a typical reflationary trade. Year-to-date (all data in this article is as of March 19), the Dow Jones, which is dominated by manufacturing companies, is up 6.6%, the S&P 500 is up 4.2%, and the Nasdaq, which is dominated by technology companies, is up 2.5%. While the Dow was near all-time highs, the S&P 500 was down 1.5% from its yearly high and the Nasdaq was down 6.2%. The U.S. Dollar Index accumulated a 1.6% gain.
Overall, rising long-term interest rates and an improving economy go hand in hand. There are only divergent views on whether the market, which has become accustomed to a flood of liquidity, can withstand a marginal convergence in monetary policy. Some argue that improved revenues are expected to hedge against rising interest rates; others argue that historical experience suggests that a stock market correction due to rising interest rates is unavoidable.
As a global wind vane for risk assets, the U.S. stock pullback triggered a global chain reaction. During the same period, the Minnesota (MSCI) Global Equity Index, Developed Equity Index and Emerging Market Equity Index retreated 1.4%, 1.1% and 6.8% respectively from their previous highs. An increase in U.S. interest rates would accelerate the return of the U.S. dollar, which would be particularly detrimental to emerging economies that are still in the midst of an epidemic.
Fed monetary policy adjustment more difficult
Further dismantling the 10-year U.S. Treasury nominal yields, real interest rates and inflation expectations (break-even inflation rate) since this year, we can find its two-stage evolution pattern from rising inflation expectations to marginal convergence of monetary policy expectations.
The first stage was from the beginning of the year to February 9, when the rise in nominal yields on U.S. Treasuries mainly contributed from rising inflation expectations, with real interest rates rising by only 2 basis points. During this phase, the FOMC continued its accommodative stance in January and would not react to the “transient” rise in inflation. The market seems to think that the current economic situation is in line with the Fed’s “average inflation target” meaning that monetary policy will not immediately respond to an appropriate upward movement in inflation. The Nasdaq also hit a new record high on February 12.
The second phase, from February 10 to the present, saw inflation expectations oscillate narrowly in the 2.2% to 2.3% range, while real yields rose 49 basis points, essentially contributing to the entire rise in nominal yields. During this period, the $1.9 trillion fiscal stimulus package passed with flying colors, further reinforcing expectations of an accelerating economic recovery. The market began to debate whether the Fed needed yield curve controls or distortionary operations to suppress the rise in long rates or depress real rates. on March 4, former New York Fed President Bill Dudley bluntly pointed out that low yields on U.S. Treasuries were unsustainable. In addition, commodity prices have risen like wildfire, copper prices have hit a ten-year high, the market is “wary” of whether this time inflation will really become a “wild horse”, the Fed’s economic forecast is too conservative.
The Fed’s policy logic is to use loose monetary policy with aggressive fiscal policy to boost inflation expectations, which in turn will stimulate economic growth and help the epidemic-damaged U.S. economy climb out of a deep hole. However, ultra-loose economic policies can fuel financial overheating, and once market inflationary expectations strengthen, U.S. Treasury yields move up too fast, potentially threatening the sustainability of the asset bubble blown up by easy liquidity in U.S. stocks. Thus, the Fed has repeatedly stressed that they are in a “wait and see” state, inflationary expectations are not terrible, substantive inflation will do. But the loophole of this logic is that the market will always run, especially the current valuation of U.S. stocks at the second highest level in history, after the Internet bubble in 2000. The disorderly exit is ultimately a “chicken scratch”.
Currently, the market and the Fed for inflation upward and no disagreement, the role of last year’s low base and this year’s fiscal stimulus is likely to make the second half of inflation in a higher position, and the market also recognizes the Fed will accept the Treasury rates upward. Only, the Fed’s judgment on inflation is based more on a long-term perspective, the reasons are broadly grouped into three points: First, the demand-side recovery is not yet complete, the real unemployment rate is high, and monetary policy is more concerned about the demand side than the supply side; second, the structural factors that inhibit potential inflation have not reversed, such as an aging population, shrinking employment and high debt pressure; third, the last economic cycle shows that the labor market overheating and will not trigger persistent hyperinflation, and that employment priority is more important than inflation. Instead, the U.S. market recognizes only one point: can monetary policy remain anchored after a significant rise in inflation?
This view may evolve three paths: the first is that upward pressure on inflation increases, U.S. Treasury yields rise too quickly, financial conditions tighten before the Fed’s monetary policy, financial markets are violently turbulent, causing the economy to turn cold, followed by the Fed to take distortionary operations or yield curve control further easing; the second is that upward pressure on inflation increases, the Fed has to do something, financial markets are violently turbulent, and leading to tighter financial conditions and a two-pronged approach to suppress inflation; the third is that inflation moves in line with the Fed’s expectations, the Fed exits slowly, and financial markets stabilize through the policy transition period. Of the three scenarios, the third is the ending that both sides are happy to see. However, when interest rates rise, the market sensitivity and amplifier role will be more prominent, resulting in the Fed more difficult to communicate.
Test the Fed’s stamina
Ultra-loose monetary policy is one of the roots of financial instability. 2001 to 2005, the U.S. low interest rate policy and the credit bubble can be seen. Warren Buffett has said that when interest rates are low, stocks will be high and vice versa. Now U.S. stocks are floating high as if they have lost their gravity. Once interest rates move up too quickly, the higher they float the more painful the fall will be.
The recent rise in U.S. Treasury yields is still bearable for the market. Although the S&P 500 Volatility Index (VIX) jumped as high as near 29, it is only about 1.4 standard deviations above its long-term trend value; the Ted spread (i.e., the difference between 3-month LIBOR and 3-month U.S. Treasury yields), which measures market liquidity conditions, is still only about 17 basis points, well below its long-term trend value of 47 basis points. Moreover, current financial market financing rates are still below the levels seen since the announcement of unlimited easing at the end of March last year, with some rates even below the levels at the end of last year.
Although the statutory obligation of the Fed’s monetary policy is price stability and employment maximization, the Fed has repeatedly emphasized the importance of financial stability to the real economy. If money is the blood, the financial system is the heart, to deliver blood to all locations of the real economy. The U.S. direct financing accounts for a relatively high proportion of the protection of capital markets is to protect the wealth of the United States. Do not intervene in the short-term fluctuations of U.S. stocks does test the Fed’s stamina, but more so, the Fed may be tangled in the future monetary policy exit how neither to pierce the asset bubble, nor to pierce the debt bubble.
After the 2008 financial crisis, the continued monetary deflation has to some extent weakened the ability of U.S. companies to clear out, barely paying interest on zombie enterprises abound, which also led to high debt in the U.S. corporate sector and government departments. If it is moderate inflation combined with higher incomes, it can help stabilize leverage in the corporate sector. However, if it is high inflation that forces interest rates to accelerate upward, the pressure on corporate sector debt will be unbearable.
In the 1980s, the Federal Reserve under Volcker “miraculously” held down high inflation through high interest rates, while allowing economic growth to accelerate back up. This time, the Fed may be ignoring the upside of inflation, hoping that inflation as expected as a natural decline, and finally succeeded in anchoring at slightly above the target of 2%. After all, U.S. President Joe Biden is committed to big investment-led growth and needs to maintain a low interest rate environment, while Congress does not want to see the debt bubble burst and mass unemployment emerge. As Fed Chairman Powell said, the rise in interest rates does not represent a tightening of financial conditions, and the accommodative monetary environment will continue.