The died Three months has given investors little to think about. Since a run on Silicon Valley Bank (svb) in March, markets first had to assess whether one American lender would collapse (yes), then others (yes, albeit thankfully few), and then whether the contagion would spread overseas (on Credit Suisse only). Bank failures seemed to have come to a halt with the May 1 takeover of First Republic, another regional lender. But then it was time to consider whether America’s politicians would wreak havoc on global markets by defaulting on their national debt. By the time this column was published, they seemed to have finally decided against it, provided an agreement between President Joe Biden and House Speaker Kevin McCarthy gets through Congress.
All of this drama has given the markets a holiday of sorts: it offered a break from the obsession with how high interest rates would have to go to curb inflation. Few things have mattered more to investors since the Federal Reserve began raising the cost of borrowing in March of last year. But after that svbThe question wasn’t how much the Fed was willing to do to fight inflation; It was about how much it would have to do to stabilize the financial system.
Attention is now turning back to interest rates. They’re on the rise again. In early May, the two-year Treasury yield, which is particularly sensitive to Fed interest rate expectations, fell to 3.75%. Since then, the figure has risen to 4.4% as officials informed journalists that they are considering raising interest rates further than their current level of 5-5.25%. Interest rate futures traders, who until recently were expecting rate cuts within months, are also now betting on a further rise.
The new mood music can also be heard outside of America. In the UK, former rate setters have warned that the Bank of England’s interest rate could rise to 6% from the current 4.5%. Treasury yields have climbed to last September’s levels, which were then only achieved on the back of fire sales and a market crisis.
For Fed Chair Jerome Powell, that could come as a relief. In early March, he seemed to have convinced investors that the central bank was serious about raising interest rates and keeping them high. He and his colleagues had spent months saying this; Traders had been trying to expose their bluff for months. But then something collapsed in the psyche of the market, and investors finally began pricing interest rates the same way the Fed did. Days later, riots broke out in the banking sector and they abandoned their bets as quickly as depositors fled svb. The fact that the market has now aligned itself with the Fed’s world view is seen as a win for the currency watchdogs.
The return of rising interest rates feels more ominous for investors. While part of the story is that the economy has held up better than expected at the start of the year, and certainly better than feared as banks began to collapse. The bigger part of the story, however, is that inflation has proved unexpectedly persistent. In April, US “core” prices, which exclude food and energy, were 5.5% higher than a year ago. Although a recession has been avoided or delayed, few forecast outstanding growth. In these circumstances, rising rates are bad for stocks and bonds. They hurt stock prices by raising the cost of corporate borrowing and reducing the present value of future profits. Meanwhile, bond prices will be forced to adjust their yields to those prevailing in the market.
Does that mean another crash like in 2022? Certainly not in the bond market. The Fed hiked interest rates by more than four percentage points last year. An additional quarter point or two gains this year would not have nearly the same effect.
However, stocks appear to be vulnerable in two ways. One is that most stock markets have been running out of momentum for some time. The S&P The 500 index of large American companies is up 10% this year, but the entire rise can be attributed to the seven largest tech stocks, all of which appear to be in control hey Euphoria. Such a tightly guided sentiment-based surge could easily be reversed. The second source of market vulnerability is earnings yield, which provides a quick guide to potential returns. The S&P 500s is 5.3%. This means shareholders are taking the risk of owning shares for an expected return that the Fed may soon offer risk-free. Stay tuned for more drama.■
Read more from Buttonwood, our financial markets columnist:
The American credit cycle is at a dangerous juncture (May 24)
How do you invest in artificial intelligence? (17th of May)
Investors are bracing for a painful crash in America’s debt ceiling (10th of May)
Also: Like the Buttonwood Column got his name
