U.S. equity markets thaw out as interest rates and inflation heat up
As most of the U.S. was digging themselves out of the snow, investors dug through a multitude of economic data, creating a volatile week for equity indices. Indices started the week higher as investors weighed positive data regarding the country’s third vaccine from J&J, slowing global cases, and the likelihood of Senate approval on the $1.9T COVID relief package expected to be approved by the Senate on March 14.
However, like the groundhog seeing his shadow, a sharp rise in interest rates and inflation expectations drove equity indexes lower in the latter half of the week as investors hunker down for what could be a longer winter and potential equity drought.
Rising rates are heating up
Interest rates continued to rise this week as fundamentals appear to be the primary driver, but technical shifts in the market exacerbated the rise as well. The 10-year Treasury yield soared more than 16 basis points Thursday to a high of 1.614%, its highest level since the pandemic shot it down to all-time lows. The trend put the benchmark rate above the S&P 12-month dividend yield, which stood at 1.52% as of Thursday at 4:00 p.m. ET, causing investors to flock to fixed-income safe havens. The primary driver is still fundamental, as investors are clearly optimistic about a post-pandemic economy and resumed economic activity, but the technical effects shouldn’t get lost in the snowstorm. The sharper rise this week can partly be attributed to MBS investors seeking to protect portfolio duration. As long-term rates rise, this leads to lower refinances and loan prepayments impacting portfolio duration. To offset the shift in duration, investors sell long-term bonds, further accelerating the rise in interest rates to what is known as convexity hedging. This may or may not be sustained over longer periods.
(Related insight: Read “Pre-issuance hedging in today’s market.")
Coinciding with the rise in medium- and long-term rates, inflation is back in economic headline news. However, despite a low correlation between rates and inflation over the past 20 years, which goes against modern economic theory, this round of fiscal stimulus is telling a different narrative. Inflation concerns in the U.S. have sparked comparison to stagnation issues that have plagued Japan for the past three decades. Japan’s policymakers’ response grew the money supply slowly. This, coupled with Japan being a net exporter, made for a rather strong currency that is prone to disinflation. Similarly, U.S. policymakers’ quantitative easing after the 2007 crisis, which also grew the money supply slowly by putting funds in the hands of banks and corporations, failed to provide inflation tailwinds as the U.S. dug itself out of the Great Recession. Unlike these two fiscal responses, the recent pandemic stimulus packages are going directly to consumers. In effect, these packages increased the broad money supply in the U.S. by 25% of GDP in 2020 alone, with more increases likely on the way in 2021. Additionally, continued USD weakening could be a contributing factor driving inflation expectations up. For better or worse, this policy divergence could lead to different outcomes regarding inflation. Adding to this sentiment, the Fed’s recent shift in policy of a 2% average inflation target and unwavering stance to keep rates low over the next one to two years could signal a focus on returning to full employment in the short run. This policy move could lead inflation to hover above 2% without raising rates. If the post-pandemic economy were to come back faster than expected, that could provide the warm weather needed for inflation and rates to rise.
(Related insight: Watch the on-demand webinar, "Semiannual Market Update for Corporations.")
Commodity prices continue to rally across the board, including oil. Both Brent and WTI are over $60/bbl and well above pre-pandemic levels.
After a volatile week, investors will check to see how the COVID relief package fairs in Congress, nonfarm payrolls and the unemployment rate along with closely monitoring 10-year Treasury yields.
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