A round trip on Wall Street
While many Australians were lamenting current travel restrictions and planning the next ‘not quite soon enough’ holiday - the market made a round trip.
Last week the US Federal Reserve showed a chink in its armour, with the closely watched ‘dot plots’ signalling that several members think interest rates may have to head higher, sooner.
This broke ranks with the previous ‘not thinking about thinking about’ raising interest rates narrative and highlighted the markets mixed views.
Why does this matter?
As we have mentioned, the rates set by central banks (either short term through the Federal Funds rate or long term via quantitative easing) provide a fundamental ‘base’ for asset prices.
How? Let’s look at the Federal Funds rate in 1980 and compare it to the yield on offer for the 10-year bond of today.
In the days of 18% interest rates (circa 1980) accepting the current yield for a 10-year bond – a rather meagre 1.50% - would make no sense. Any sensible investor would surely demand an equal, if not higher rate for locking their capital up for 10 years.
But in today’s world, where the Federal Funds rate is 0.06%, a 1.5% rate is attractive to some.
Extrapolating this we can see why the level of interest rates is fundamental to the price of all assets.
The higher the interest rate on relatively ‘risk-free’ securities like government bonds (that is risk of default – not loss in purchasing power!), the higher the return you should demand from other assets.
Hence there is a focus on parsing every word, data point and a skerrick of information that is sent the market’s way when it comes to central bank policy and deducing when and how fast rates will rise.
How did the market react?
The market fell and fell. And rose and rose again. The S&P500 began last week at 4255, fell by 3% by Friday only to end back at 4246 on Tuesday.
There is some cognitive dissonance afoot.
The relevant questions continue to be:
- What will be the impact of the extreme fiscal spending and money creation over the past year? Will it continue?
- Will inflation be a ‘transient’ phenomenon? Is it here to stay? Is there a risk of it running hotter than expected?
- How will various policy levers influence the trajectory of the above?
The message that the market took on Wednesday was that the Federal Reserve is contemplating applying the breaks sooner than its rhetoric would indicate and that it is becoming more concerned about inflation.
Hence the reaction we saw was technology stocks (whose kryptonite is inflation/higher rates) went up and commodities (who love growth and inflation) went down.
However, by Tuesday we were back to where we started.
Any notion of a sooner than expected rise in rates was quickly rebuked by a speech on Monday, Federal Reserve chairman Jerome Powell who indicated the US economy still had a “long way to go”. Voila – the market rebounded.
Source: IRESS, First Samuel
The jitters on display last week demonstrated just how important the three questions posed above are to the outlook for client portfolios.
There may be some more volatility ahead– hence we are holding higher levels of cash.
We think it is foolish to not acknowledge, at the very least, the potential for a change in the current paradigm. This includes one where central banks no longer captain the ship.
There is a scenario where interest rates are kept low (or repressed) while inflation runs relatively hot. In these conditions, investors lose purchasing power. We see this as the key risk over the next 5 years.
The market’s hair-trigger reaction last week demonstrated it is concerned about inflation, its impact on rates and liquidity.
We agree and have expressed this as a portfolio that is buttressed by a healthy amount of inflation beneficiaries.