Foundational Changes in Stocks and Bonds
It’s a small world, and as we’ve seen, if something happens with one trading partner, it impacts them all.
Rapid moves and turnarounds in the U.S. Treasury market, considered the bedrock of all other markets, have increased the volatility in equity markets, commodities trading, and, more directly to, currency exchange rates across the globe. The uncertainty has caused investment capital to gravitate to U.S. markets; however, prolonged gyrations, especially in “risk-free” U.S. Treasuries, could put many investors on the sidelines and weaken asset prices globally.
The U.S./U.K. Example
At the end of 2021, the ten-year U.S. Treasury note was yielding 1.5%. Earlier this week a ten-year U.S. Treasury (backed by the same entity that backs the U.S. Currency) rose to yield 4%. That’s a 270% rise in the yield – for bondholders, prices of bonds decline as yields rise. So while the stock market frets over what a Federal Reserve increase in rates may do for equities, bond market investors can usually pull out a calculator and get a fairly precise answer as to how bonds will reprice. If the reaction is radically different, an important foundation is lost. The reaction has been unpredictable.
While the ten-year did hit 4% this week, after lingering around 3.50% the prior week, the yield abruptly dropped after news from across the Atlantic that England’s central bank, the Bank of England (BOE), was taking steps to halt rate increases, effectively implementing quantitative easing. The BOE buying bonds puts pound sterling into their economy and adds to inflation pressures. The immediate reaction was for rates to come down, there, in the U.S., and in other economies that have been tightening. This provided a feeling of relief from equity markets, as it was a sign that the central banks may one by one abandon their plans to fight inflation, choosing instead to fuel it.
The BOE’s move to buy bonds “on whatever scale is necessary” to stabilize its bond market, a move that followed large tax cuts last week by the U.K. government, despite double-digit inflation, many believe indicates a possible problem with a major financial institution or pension fund.
The world’s markets don’t trade in a vacuum. The sudden reversal in the U.K. to stop interest rate hikes and perhaps lower rates brought a positive tone to stocks and bonds in U.S. markets, each having historically challenging years. The conversation in the U.S. is that the Fed may have to pause its own aggressive direction. This would be either because increased rates would further strengthen the dollar, or because the U.S. may have its own underlying time bomb(s), institutions that would fail or bubbles that could burst.
The rallies in the U.S. stock and bond markets gained momentum after the BOE move as the Chicago Mercantile Exchange (CME) data showed reduced expectations of a terminal or neutral Fed Funds rate of 5%, with expectations now for the policy rate to top out around 4.25-4.5%.
Take Away
While the Fed taking its foot off the brake pedal would be a remarkable turnaround after Chairman Powell’s efforts to be clear about his intent to tighten, the reasons for the CME data shift are twofold. First, the Fed won’t be able to keep aggressively raising rates ad simultaneously reducing bond holdings (shrink its balance sheet), because the strong U.S. dollar is disrupting global markets. Secondly, as mentioned before, checking the health of major institutions, housing, and pension funds in the U.S. may be prudent before administering more economic medicine.
Uncertainty has the effect of investors pulling assets out of markets and businesses acting with more caution. Hopefully, clarity, one way or the other, soon presents itself so volatility is reduced and investors can better understand the playing field.
Paul Hoffman Managing Editor, Channelchek
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