Investors have become addicted to low rates

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The critical questions were, and remain, when and to what extent he could act.

Bringing forward when U.S. rates might start rising from 2024 to 2023 shouldn’t have come as a shock to investors who have focused on inflation numbers for much of this year.

Markets, especially stock markets, will remain very sensitive to even the most nuanced comments from Fed officials about reducing asset purchases or potentially raising interest rates.

This perhaps underscores how tense and sensitive stock valuations have become – and vulnerable to the slightest hint of shifting monetary policy parameters – as post-pandemic “reflation” trading has added yet another push to policy measures. valuation already stretched.

The most interesting and stimulating reaction to the news that scared the stock markets last week came from the bond market.

One would have expected bond yields to soar and the yield curve to steepen with the prospect of the Fed cutting its bond purchases and moving forward when it would start raising rates. They did not do it.

Earlier this year, 10-year rates were climbing, seemingly inexorably, towards 2% and breakevens were exploding, with investors anticipating the spike in inflation rates would force the Fed down.

That trade, however, collapsed amid the Fed’s still-dovish comments and this trend continued during the stock market turmoil of the past week.

Bringing forward when U.S. rates might start rising from 2024 to 2023 shouldn’t have come as a shock to investors who have focused on inflation numbers for much of this year.Credit:PA

The yield on 10-year bonds fell from 1.58% last Wednesday to 1.48% as the yields on two- and five-year bonds rose, flattening the yield curve. Inflation expectations, measured by “breakeven points” – comparisons of longer-term securities with their inflation-protected counterparts – have retreated.

The bond market has bought the thesis that the Fed has promoted that there will be a surge in inflation in the near term as the economy rebounds from its pandemic-induced nadirs, but it will decline relatively quickly once the economy recovers. will have reopened and will operate normally.

He also seems to incorporate the assumption that the Fed will be slow to act and that when it does, it will be ultra-cautious.

This matches the change in the Fed’s policy framework last year, from one that positioned it to act preemptively to avoid a surge in expected inflation to one where it reacts to a higher rate of inflation. to his two percent goal after the fact. .

Equilibrium Rates examine the short-term confusion created by reopening the economy amid supply chain bottlenecks, travel and other restrictions, residual risk aversion and their consequences. impacts on economic data and see growth and inflation rates moderate. and normalize in the medium term to fairly modest levels.

The stock market rebound – the Dow Jones followed its worst week in eight months rising 1.8% and the S&P 500 rising 1.4% – came despite comments Monday from two bank presidents of the Federal Reserve, James Bullard of St Louis Fed. and Robert Kaplan of the Dallas Fed, suggesting that the Fed should take its foot off the accelerator as soon as possible.

Their views were balanced by those of one of the most influential Fed bank chairmen (and vice chairman of the Open Market Committee), John Williams of New York.

Williams said that while it was clear that the U.S. economy was improving at a rapid pace, data and conditions had not improved enough for the Fed to change its monetary policy and move away from its strong support. to economic recovery.

Markets, especially stock markets, will remain very sensitive to even the most nuanced comments from Fed officials about reducing asset purchases or potentially raising interest rates.

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While there has historically been an inverse correlation between interest rates and the stock markets, the fanciful multiples at which stocks trade – the S&P 500 at around 30 times earnings and big tech stocks close to 50 times – can only be justified if the US economy continues to rebound and maintains above-average growth rates for at least the next two years.

This would inevitably prompt a reaction from the Fed by lowering its bond purchases and raising the fed funds rate from its emergency levels to zero or near zero. These actions, if the Fed arrives at the right time and avoids a real surge in inflation, would be positive (or should be seen as positive) for longer-term equity markets.

In the short term, of course, markets will continue to overreact, or overreact, to any suggestion, however slight, that the monetary policy parameters that have pushed them to their current highs might change – even as those changes are underway. response to good economic conditions. new.

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