New applications for U.S. unemployment benefits fell unexpectedly last week to the lowest level since mid-February, signaling the job market remains tight even as broader economic headwinds build.
Initial jobless claims declined by 13,000 to 216,000 in the week ended September 2, the Labor Department reported Thursday. That was below economist forecasts for a rise to 234,000 and marked the fourth straight week of declines.
Continuing claims, which track ongoing unemployment, also dropped to 1.679 million for the week ended August 26. That was the lowest point since mid-July.
The downward trend in both initial and continuing claims points to ongoing resilience in the labor market amid strong employer demand for workers.
There are some emerging signs of softness, however. The unemployment rate ticked higher to 3.8% in August as labor force participation increased. Job growth also moderated in the latest month, though remains healthy.
Worker productivity rebounded at a 3.5% annualized pace in the second quarter, the fastest rise since 2020. Moderating labor cost growth could also help the Federal Reserve combat high inflation.
While jobless claims remain near historic lows, economists will keep a close eye on any notable changes that could indicate potential layoffs, although the Federal Reserve has recently taken a more measured approach to rate hikes aimed at moderating economic demand.
Currently, the most recent data confirms a remarkably robust job market, despite concerns about inflation and slowing growth. This resilience provides hope that any potential economic downturn in the future might be less severe than previously anticipated.
Stocks, Bonds, and Real Estate Markets are All Impacted By U.S. Debt Levels
Who will buy all the U.S. Treasury debt issuance? This week the Treasury Department hinted at its borrowing needs estimate for the third quarter. Its estimated need is $1 trillion-plus, the largest third-quarter need ever. At the same time, the Federal Reserve is reducing its holdings of U.S. debt by a cumulative $90 billion each month, and the U.S. dollar is on a weakening trend which reduces demand for dollar-denominated assets. There are now concerns being raised about the extent to which domestic and foreign demand for U.S. debt issuance will be able to grow to match issuance.
More details surrounding the Treasuries financing needs will be released at 8:30 on Wednesday August 2nd. The large estimate already shared in advance, $1.007 trillion, has analysts beginning to conclude that the U.S. could become hampered with a deteriorating fiscal deficit outlook amid continuing pressure to borrow more.
Two months ago, analysts at Fitch Ratings, a bond credit rating company, put the United States on Rating Watch Negative (RWN) citing, among other things, “fiscal and debt trajectories.” The initial ratings watch came at a time when there was uncertainty about whether the U.S. debt ceiling would be raised. It was not only increased, on June 2nd President Biden signed Congresses bill removing any upper limit on debt issuance until January 2025. The increase in debt, reduced number of buyers, lack of fiscal guardrails, and already higher interest rates on rollover debt could have consequences for all markets. Fitch may be prompted to replace the AAA rating on US Treasuries by assigning a lower rating.
At stake for the broader fixed-income market is that most corporate debt issuance is spread to U.S. Treasury rates of similar duration bonds. If large ongoing auctions over the third quarter deplete demand at market levels Treasury yields would have to trade higher, or government debt would face being illiquid or even default.
In the past U.S. Treasury borrowing need has been met by the perceived safety in the country’s ability to prosper and pay its debts, as well as the reliability of the U.S. dollar as a reserve currency. It’s unclear with less stable relations with China (a large holder of U.S. debt) and the BRICS nations plans to create a gold-based fiat currency, if demand will shrink or grow while U.S. debt issuance climbs.
At stake for the broader real estate market, which is heavily leveraged and therefore greatly impacted by interest rate expenses, is for the cost of borrowing to rise should demand for Treasuries not meet new issuance levels. Thirty-year residential loans are spread off ten-year Treasuries. Further increases in mortgage rates would serve to slow down real estate transactions.
The stock market would likely become bifurcated with stocks tied to big ticket items, typically bought by securing financing, weakening, and stocks that benefit from a strong dollar (higher comparative rates strengthen a native currency) could also do well. These stocks include companies that don’t have a large overseas customer base — if they are net importers, they may benefit even more. Companies that have large borrowing needs, will find their cost of capital has increased as they compete with U.S. Treasury rates. This is why small cap companies, that have very little borrowing needs, tend to perform better than large-cap companies with high debt levels in similar industries.
One Federal government expense that it can’t exercise immediate control over is the interest rate expense of its debt. Over $32 trillion in debt, spread out to mature through 30 years, now holds an average rate of near 2.50%. New debt is issued with almost double that interest rate. This is evident in the chart above that shows interest on debt from 2020 until today increased by $400 billion – with no expected change in its growth rate.
In a Tuesday note title “Treasury Tsunami,” rates strategists at Barclays Anshul Pradhan and Andres Mok wrote, the “Treasury’s latest financing estimates point to a worsening fiscal profile” and “the fiscal picture has worsened significantly since last year.” They point to the likelihood of “a sharp increase in the supply of notes and bonds over the coming quarters,” and cautioned investors against expecting “a typical end-of-cycle bond market rally.”
Whether or not the Fed continues to remain hawkish, if this recipe of greater U.S. debt issuance need continues on its trajectory, with fewer buyers, interest rates will rise. For investors with the common 60/40 portfolios, that is to say 40% in bonds, higher rates will mathematically cause prices of their fixed income holdings to decline. They may receive interest payments every six months, but if interest rates keep increasing, what others are willing to pay for that payment stream declines. In this way, bonds and other fixed income is only the place to hide if you want to be certain of declining values of your holdings.
Take Away
The Fed could stop tightening, and still there would be upward pressure on Treasury rates because of increased supply. Interestingly, this would serve to create a normally sloped yield curve (not inverted) which, according to many that were saying this year’s inverted yield curve is an unmistakable sign of impending recession, they would have another chance at being wrong again by saying an upwardly sloping yield curve is signs the market expects robust growth. Taken in the context of all of 2023s market dynamics and manipulations, neither textbook simplification fits.
If the scenario of higher rates out on the curve unfolds, a higher cost of capital will impact some industries more than others, and international companies differently than pure domestic operations. Consider this as you make your own interest rate and economic projections and adjust your holdings accordingly.
Interest Rate Increases are Less Frightening When the Impact is Understood
The fixed income market, and the interest rates market in general have a pronounced role in shaping stock market dynamics and equity investor sentiment. At a minimum, higher rates, the cost of money, when increasing, will most directly impact businesses that borrow as part of their normal activity. Other industries find that growing profits is more difficult in a less direct way. And then there are actually sectors that can benefit from an upward-sloping yield curve. Below we cover five different ways that higher interest rates impact stocks, and mention sectors that may be especially hurt, and some that could even thrive if the rates continue to climb higher.
Background
The U.S. central bank, The Federal Reserve has raised overnight interest rates from nearly 0.00% to near 5.25%. Longer-term rates have not followed in lock-step as other dynamics such as future economic expectations, flight to quality, and Fed yield-curve-control have caused longer rates to continue to lag below short-term interest rates.
In recent days there has been some selling in bonds which has driven longer interest rates up. The overall reason is the rekindled belief that the Fed is not finished tightening after the FOMC minutes from June indicated such. But other factors such as investors doing break-even analysis on longer term bonds and then raealizing they may not be getting paid enough interest to offset inflation, or to benefit them more than rolling shorter maturities that may be paying 200bp higher.
The sudden increase in rates, especially the ten-year US Treasury Note which is a benchmark for many lending rates, including mortgages, has caused stock market participants to feel unsettled. Some of their fears may be justified, some may not be.
Five Ways Higher Interest Rates Impact Equities
#1 Higher Rates Impact on Equity Valuations
One of the primary concerns for stock market investors, when interest rates rise, is the potential impact on equity valuations. As interest rates increase, the discount rate used to value future cash flows is then higher. This can put downward pressure on equity valuations, particularly for stocks with high price-to-earnings ratios. Investors become concerned about the potential decline in stock prices and the overall effect on the market’s valuation levels.
#2 Profitability of Interest Rate-Sensitive Sectors
Some sectors are particularly interest rate sensitive. Utilities for example, might have a couple of things working against them. First off, they are notorious for carrying a high level of debt. As this debt needs to be refinanced (as bonds mature), the new bonds need to be issued at higher rates, increasing the utility’s cost of doing business.
Utilities also are popular investments among dividend investors. As yields on bonds increase, there is more competition for income investors to choose from, at times with lower risk, which makes utility stocks less attractive.
As one might imagine REITs, by definition, all have real estate as underlying assets. Rising interest rates can increase borrowing costs for REITs involved in property acquisitions and development. This can potentially affect their profitability and underlying property valuations.
As with utilities, the REIT sector attracts income investors; if bonds become a more attractive alternative, this creates lower demand for REIT investing.
Financial institutions are certainly impacted, however, depending on the segment within financials, some may benefit from increased profit margins, while others are weighed down by increased costs. Basic banking is borrowing short and lending out longer, then managing the risk of maturity mismatch. As longer-term rates rise relative to shorter rates, these institutions find their earnings spread increases.
In recent years the trend has been, especially for larger banks, to create loans and then sell them. They profit on the servicing side, or administrative fees to create the loan. In this way they are shielded from interest rate mismatch risk, and they can make more loans on the same deposit base (selling the loans replenished the funds they can loan from). So the benefit of rising rates on benchmark securities relative to the banks deposit rates could have much less positive impact than it might have if they held the loans. What may actually happen within these institutions is that they experience fewer loans as consumers and business borrow take fewer loans, thus earning less fee income.
#3 Investors Lean Toward Bond Investments
The return on anything is the present value, versus future value, over time held. Higher interest rates can make fixed-income investments more attractive than low rates compared to stocks. When interest rates rise, more investors prefer a known return in terms of interest payments than an unknown move in stocks valuations. This shift in investor preferences can lead to reduced demand for equities and potentially impact stock market performance.
Investors buying bonds as rates are rising will experience a decrease in the value of their fixed income securities. So, they may be surprised to learn that they avoided stocks because stocks may go down in value, and instead invested in fixed income which mathematically will go down in value when rates rise.
#4 Borrowing Costs for Companies
As mentioned earlier, rising interest rates increase the borrowing costs for companies. This can impact corporate profitability and investment decisions, which in turn can affect stock prices. Companies that rely heavily on debt financing may experience higher interest expenses, potentially squeezing profit margins. Investors become concerned about the potential impact on corporate earnings and the overall financial health of companies in a higher interest rate environment.
Analyzing a company’s capital structure, and looking for signs of low debt levels, or long-term debt that is locked in at the low interest rates of the early 2020’s, may be a good way to filter companies that have a profit advantage over their competitors
#5 Consumer Spending and Business Investment
Consumer spending levels are a direct driver in consumer stocks. When borrowing becomes more expensive, consumers may reduce their discretionary spending. This can impact businesses that rely on consumer demand, potentially leading to lower revenues and profitability. The stocks that tend to hold up more when spending levels decrease are those that produce necessities.
Business investment during periods of rising interest rates can influence investment decisions for businesses. As borrowing costs increase, companies may reduce or delay capital investments, expansions, or acquisitions. This cautious approach can impact economic growth and overall industry development, which can in turn affect its performance, for much longer than a quarter or two.
Take Away
Stock market investors have legitimate concerns about the impact of higher interest rates on their investments. The potential effects on equity valuations, profitability of interest rate-sensitive sectors, investor preferences for fixed-income investments, borrowing costs for companies, and consumer spending/business investment are key factors that contribute to investor apprehension. It is as important for investors to monitor interest rate trends and understand the impacts as it is for them to monitor.
Investors Receiving a 5% Yield are Losing to Inflation
The CPI inflation report and the Fed’s relentless increases in Fed funds levels have pushed the six-month US Treasury Bill (T-Bill) above 5%. This is the first time since 2007 that this low-risk investment has topped 5%. Last year on this date, the six-month T-Bill was 0.76%. While the stock market is concerned that higher borrowing costs will have the Fed’s intended effect of slowing demand, rates are reaching a point where another concern creeps in. The concern is will traditional stock investors lay back and be satisfied getting paid interest.
More likely, the high cash position represents “dry powder” waiting for an opportunity.
Short Term Rates
Money Market fund assets were $4.81 trillion for the week ended Wednesday, February 8, according to the Investment Company Institute. Just shy of the record MF balances reported in January. Higher than average cash levels have often been thought of as a bullish sign as it represents potential to drive stock prices up when flows toward equities increase.
This may be part of the situation as we come off a dismal 2022 for equities, but there is likely something else incentivizing the retreat to safety. The higher interest rates are in the short end of the curve, investors are getting paid to retreat. High-yielding cash equivalents with six-month T-Bills now at 5% (10-year Treasuries are only 3.75%) may be more than a parking place. It may represent an alternative investment with a much more assured return.
With inflation at 6.4%, the answer is no. But it is definitely preferable to seven of the periods on the 10-year chart above. And with January’s consumer price index (CPI) report revealing signs of sticky to reaccelerating inflation, the Federal Reserve is more likely to be hiking rates for longer than expected.
For investors looking to invest for longer periods, the stock market handily beats inflation. In other words, for the various time frames below, S&P 500 investors did not see their assets erode due to inflation.
Beating inflation is foundational to investing. Far exceeding it is the goal of many. Investors are not doing this choosing cash, in fact they are choosing to lose buying power rather than risk that the market doesn’t perform as it has historically.
Data released on Tuesday February 14 showed the inflation rate (CPI) slowed to 6.4% in January. The cost of goods and services rose 0.5% during the month. The half percentage is the largest one month erosion of purchasing power in three months.
Investors content with 4%-5% returns should consider that they are losing ground to persistent inflation.
Investors with a five-year time horizon or longer should weigh the risks of earning yields below the inflation rate to the ups and downs of stocks. In fact, as more do, the 4-5 trillion in cash can make or quite a bull market.
Why the Fed Needs to Gain Trust, Gain Momentum, and Gain More Yards
Monetary policy and its implementation is as much sport as science. Economics is actually a social science, so it relies on human behavior to mimic past behaviors as its prediction guide. But as in sports, victory is difficult if there is distrust in the coach that’s calling the shots (in this case Powell), or if there are people on your side that have reason to work against you, (an example would be Yellen). Consistency in blocking and tackling (doing the right thing) and not giving up, over time, wins games. Knowing what to expect from the opposing team (consumers) wins a healthy economy.
One repeated trait in monetary policy is that there is a lag between implementation (easing or tightening) and a change in economic conditions. It isn’t a short lag, and the impact varies. Since it could take more than a year for a policy change to begin to impact the economy, the Fed usually moves at a slow and measured pace in order to not overdo it.
The slow pace allows policymakers to observe the impact of their moves and change tactics (positions on the playing field) mid-game.
Federal-Funds Rate During Tightening Cycles
Note: From December 2008, midpoint of target range. December 2015 hike excluded from 2016-18 cycle
Source: Federal Reserve
Over the past nine months, we have been in a tightening cycle. During this period, the Fed has raised rates by 3.75%. On average (since 1975), when the Fed has tightened rates, they are notched up by 5.00% over 20 months.
The Fed’s current pace is faster than average. This is because inflation took them by surprise, and rose rapidly. Putting up a strong defense against inflation that has been rampant is necessary to not be shut out and allow the Fed to gain control over the outcome.
Because one has to be able to reflect back more than 40 years to have experienced the Fed raising rates this fast. Many have lost confidence in its ability, and are in their own way working against a winning outcome.
Pace of Fed Hiking Cycles
Note: From December 2008, the midpoint of target range
Source: Federal Reserve
The stock and bond markets move in group anticipation of expected policy moves by the Fed. This has been more pronounced in recent years as the Fed has basically shared its expectations after each meeting, setting up for the next. Higher rates make bonds and bank deposits more attractive. Higher rates also weaken the economy and corporate profits, and that induces investors to move away from stocks and even real estate.
Bonds now offer the highest yields since 2007. The stock market may have anticipated what was to come as it peaked in early January of this year, more than two months before the Fed began hiking in March.
Fed Hikes and S&P 500 Bear Markets
Sources: Federal Reserve; Dow Jones Market Data
Sources: Federal Reserve; Dow Jones Market Data
Employment
The Fed is concerned with a wage-price spiral feeding on itself. It likely won’t be satisfied that its tightening has been sufficient until it can be confident that it has avoided a wage-price storm on the economy.
Ideally, this would happen without unemployment rising. Soft landings took place in 1983-84 and 1994-95. But when inflation starts out too high, as it is now, unemployment usually rises notably, and a recession occurs.
Historically, this doesn’t happen until several years after the first increase. This time it is hoped it will be different, since the Fed is playing more aggressively.
Periods of Fed Hiking and Rising Unemployment
Note: The unemployment rate rose to 3.7% in October, up from the pandemic low of 3.5% a month earlier. Sources: Federal Reserve; Labor Department
Inflation
Historically, inflation has only fallen to acceptable levels after unemployment has increased, and long after the first rate increase – the exact timing has varied. If the fall in core inflation (which excludes the volatile food and energy components) between September and October continues, and September proves to be the peak, the time between the first Fed increase and the high point of inflation will be one of the shortest of any Fed hiking cycle.
Often, the break in inflation has been accompanied by a recession. The economy receded in each of the first two quarters and then grew in the third. The changes in the inflation component in Gross Domestic Product may have borrowed from one quarter and have been additive to the next. The fourth quarter reading should help level the growth averages out to see if we were indeed in a shallow recession.
Proximity of Peak Inflation and Recessions to Initial Rate Hikes, from Year Hiking Cycle Began
Note: Inflation refers to core CPI.
Sources: Federal Reserve; Labor Department
Take Away
As in many team sports, once one side gets momentum, they are difficult to stop . The Fed needs to gain the trust of the individual players in the economy in order to be successful. Saying one thing, then doing another, would undermine this trust. So far, despite the Fed originally being wrong about inflation, the Fed has done what it has said it would do. Stock and bond markets, which are a considerable part of the economy, have been slow to understand the Fed’s resolve.
It has been implementing the balance sheet run-off plan and raising rates toward a level it believes would equate to a future 2% inflation rate. Like so many other things in the social sciences, widely held expectations of the future become self-fulfilling.
The health of the US Treasury market impacts almost all other markets. This is because the “risk-free” market (US Treasuries) and its relationship to the US dollar is the foundation from which other markets stand. If it is in trouble, all markets suffer. The “health” measure most associated with securities like treasuries is liquidity or whether money can be raised when needed. Other measures include market spread between the bid and the ask, trading activity levels, and price impact or how a large transaction impacts the price.
A just released report by New York Fed economists Michael Fleming and Claire Nelson discuss the current state of the U.S. Treasury markets from the unique point of view and access to information of the New York Fed.
The report follows:
How Liquid Has the Treasury Market Been in 2022?
Policymakers and market participants are closely watching liquidity conditions in the U.S. Treasury securities market. Such conditions matter because liquidity is crucial to the many important uses of Treasury securities in financial markets. But just how liquid has the market been and how unusual is the liquidity given the higher-than-usual volatility? In this post, we assess the recent evolution of Treasury market liquidity and its relationship with price volatility and find that while the market has been less liquid in 2022, it has not been unusually illiquid after accounting for the high level of volatility.
Why Liquidity Matters
The U.S. Treasury securities market is the largest and most liquid government securities market in the world. Treasury securities are used to finance the U.S. government, to manage interest rate risk, as a risk-free benchmark for pricing other financial instruments, and by the Federal Reserve in implementing monetary policy. Having a liquid market is important for all these purposes and thus of great interest to market participants and policymakers alike.
Measuring Liquidity
Liquidity typically refers to the cost of quickly converting an asset into cash (or vice versa) and is measured in a variety of ways. We consider three commonly used measures, calculated using high-frequency data from the interdealer market: bid-ask spreads, order book depth, and price impact. The measures are for the most recently auctioned
(on-the-run) two-, five-, and ten-year notes (the three most actively traded Treasury securities, as shown in this post) and are calculated for New York trading hours (defined as 7 a.m. to 5 p.m.). Our data source is BrokerTec, which is estimated to account for 80 percent of trading in the electronic interdealer broker market.
The Market Has Been Relatively Illiquid in 2022
The bid-ask spread—the difference between the lowest ask price and the highest bid price for a security—is one of the most popular liquidity measures. As shown in the chart below, bid-ask spreads have widened out in 2022, but have remained well below the levels observed during the COVID-related disruptions of March 2020 (examined in this post). The widening has been somewhat greater for the two-year note relative to its average and relative to its level in March 2020.
Bid-Ask Spreads Have Widened Modestly
Liberty Street Economics chart plots the five-day moving averages of average daily bid-ask spreads for the two-, five-, and ten-year notes in the interdealer market from January 2, 2019, to October 31, 2022.
Source: Authors’ calculations, based on data from BrokerTec.
Notes: The chart plots five-day moving averages of average daily bid-ask spreads for the on-the-run two-, five-, and ten-year notes in the interdealer market from January 2, 2019, to October 31, 2022. Spreads are measured in 32nds of a point, where a point equals one percent of par.
The next chart plots order book depth, measured as the average quantity of securities available for sale or purchase at the best bid and offer prices. Depth levels again point to relatively poor liquidity in 2022, but with the differences across securities more striking. Depth in the two-year note has been at levels commensurate with those of March 2020, whereas depth in the five-year note has remained somewhat higher—and depth in the ten-year note appreciably higher—than the levels of March 2020.
Order Book Depth Lowest since March 2020
Liberty Street Economics chart plots five-day moving averages of average daily depth for the two-, five-, and ten-year notes in the interdealer market from January 2, 2019, to October 31, 2022.
Source: Authors’ calculations, based on data from BrokerTec.
Notes: The chart plots five-day moving averages of average daily depth for the on-the-run two-, five-, and ten-year notes in the interdealer market from January 2, 2019, to October 31, 2022. Data are for order book depth at the inside tier, averaged across the bid and offer sides. Depth is measured in millions of U.S. dollars par.
Measures of the price impact of trades also suggest a notable deterioration of liquidity. The next chart plots the estimated price impact per $100 million in net order flow (that is, buyer-initiated trading volume less seller-initiated trading volume). A higher price impact suggests reduced liquidity. Price impact has been high this year, and again more notably so for the two-year note relative to the March 2020 episode. That said, price impact looks to have peaked in late June and July, and to have declined most recently (in October).
Price Impact Highest since March 2020
Liberty Street Economics chart plots the estimated price impact per $100 million in net order flow for the two-, five-, and ten-year notes in the interdealer market from January 2, 2019, to October 31, 2022.Source: Authors’ calculations, based on data from BrokerTec.
Notes: The chart plots five-day moving averages of slope coefficients from daily regressions of one-minute price changes on one-minute net order flow (buyer-initiated trading volume less seller-initiated trading volume) for the on-the-run two-, five-, and ten-year notes in the interdealer market from January 2, 2019, to October 31, 2022. Price impact is measured in 32nds of a point per $100 million, where a point equals one percent of par.
Note that we start our analysis of liquidity in this post in 2019 and not earlier. One reason is to highlight the developments in 2022. Another reason is that the minimum price increment for the two-year note was halved in late 2018, creating a break in the note’s bid-ask spread and depth series. Longer time series of bid-ask spreads, order book depth, and price impact are plotted in this post and this paper. The longer history indicates that the price impact in the two-year note is currently at levels comparable to those seen during the 2007-09 global financial crisis, as well as in March 2020.
Volatility Has Also Been High
Pandemic-induced supply disruptions, high inflation, policy uncertainty, and geopolitical conflict have led to a sizable increase in uncertainty about the expected path of interest rates, resulting in high price volatility in 2022, as shown in the next chart. As with liquidity, volatility has been especially high lately for the two-year note relative to its history, likely reflecting the importance of near-term monetary policy uncertainty in explaining the current episode. Volatility has caused market makers to widen their bid-ask spreads and post less depth at any given price (to manage the increased risk of taking on positions), and for the price impact of trades to increase, illustrating the well-known negative relationship between volatility and liquidity.
Price Volatility Highest Since March 2020
Liberty Street Economics chart plots five-day moving averages of price volatility for the two-, five-, and ten-year notes in the interdealer market from January 2, 2019, to October 31, 2022.
Source: Authors’ calculations, based on data from BrokerTec.
Notes: The chart plots five-day moving averages of price volatility for the on-the-run two-, five-, and ten-year notes in the interdealer market from January 2, 2019, to October 31, 2022. Price volatility is calculated for each day by summing squared one-minute returns (log changes in midpoint prices) from 7 a.m. to 5 p.m., annualizing by multiplying by 252, and then taking the square root. It is reported in percent.
Liquidity Has Tracked Volatility
To assess whether liquidity has been unusual given the level of volatility, we provide a scatter plot of price impact against volatility for the five-year note in the chart below. The chart shows that the 2022 observations (in blue) fall in line with the historical relationship. That is, the current level of liquidity is consistent with the current level of volatility, as implied by the historical relationship between these two variables. This is true for the ten-year note as well, whereas for the two-year note the evidence points to somewhat higher-than-expected price impact given the volatility in 2022 (as also occurred in fall 2008 and March 2020).
Liquidity and Volatility in Line with Historical Relationship
Liberty Street Economics chart plots price impact against price volatility by week for the five-year note from January 2, 2005, to October 28, 2022.
Source: Authors’ calculations, based on data from BrokerTec.
Notes: The chart plots price impact against price volatility by week for the on-the-run five-year note from January 2, 2005, to October 28, 2022. The weekly measures for both series are averages of the daily measures plotted in the preceding two charts. Fall 2008 points are for September 21, 2008 – January 3, 2009, March 2020 points are for March 1, 2020 – March 28, 2020, and 2022 points are for January 2, 2022 – October 29, 2022.
The preceding analysis is based on realized price volatility—that is, on how much prices are actually changing. We repeated the analysis with implied (or expected) price volatility, as measured by the ICE BofAML MOVE Index, and found similar results for 2022. That is, liquidity for the five- and ten-year notes is in line with the historical relationship between liquidity and expected volatility, whereas liquidity is somewhat worse for the two-year note.
Note also that while liquidity may not be especially high relative to volatility, one might then ask whether volatility itself is unusually high. Answering this question is beyond our scope here, although we will note that there are good reasons for volatility to be high, as discussed above.
Trading Volume Has Been High
Despite the high volatility and illiquidity, trading volume has held up this year. High trading volume amid high illiquidity is common in the Treasury market, and was also observed during the market disruptions around the near-failure of Long-Term Capital Management (see this paper), during the 2007-09 financial crisis (see this paper), during the October 15, 2014, flash rally (see this post), and during the COVID-19-related disruptions of March 2020 (see this post). Periods of high uncertainty are associated with high volatility and illiquidity but also high trading demand.
Nothing to Be Concerned About?
Not exactly. While Treasury market liquidity has been in line with volatility, there are still reasons to be cautious. The market’s capacity to smoothly handle large flows has been of ongoing concern since March 2020, as discussed in this paper, as Treasury debt outstanding continues to grow. Moreover, lower-than-usual liquidity implies that a liquidity shock will have larger-than-usual effects on prices and perhaps be more likely to precipitate a negative feedback loop between security sales, volatility, and illiquidity. Close monitoring of Treasury market liquidity—and continued efforts to improve the market’s resilience—remain important.
Will the November Fed rate announcement cause a stock market rally?
The next time the Federal Reserve is expected to adjust the target range of the Fed Funds overnight lending rate is Wednesday, November 2nd. Few have doubt at this point that this will again be a 0.75% increase. That level is already baked into equities. Stock market strength and direction shouldn’t veer much from the rate move but could dramatically turn as a result of the Fed’s forward guidance. If Chairman Powell & Co. suggests a slower benchmark lending rate increase, it would be a very welcome sign for investors.
Focus on the Post Meeting Announcement
There are already signs the Fed may slow the pace of Fed Funds increases. There are also indications it may alter its quantitative tightening (QT) in a way that could quicken a yield curve steepening. In other words, the speed of QT may increase. To date, the real rate of return on bonds, of most all maturities, is viewed as unnatural as they are below zero (Yield – Inflation = Real Rate). While an increase in QT may do more to raise rates and reduce the money supply, the effect is stealthier; it doesn’t provide a panicky headline for investors to react to abruptly.
Some Fed governors have already shown signs that they believe the best course from here is to slow the ratcheting up of the funds level and perhaps even stop raising Fed Funds rates early next year. A hiatus would allow them time to see if the moves have had an impact and give members a chance to see if further moves are prudent. The Fed always runs the risk of overreacting and going too far when tightening; this “oversteering” by previous Feds has occurred a high percentage of the time as they contend with a lag between monetary policy shifts and economic reaction.
Where We Are, Where We’re Going
In the most aggressive pace since early 1980, so far in 2022, the Fed raised its benchmark federal-funds rate by 0.75 points at each of its past three meetings. The most recent move was in late September. This left the overnight interest rate at a range between 3% and 3.25%.
The stock market wants the Fed to slow down. It rallied in July and August on expectations that the Fed might slow the pace of increase. Slowing, at least at the time, would have conflicted with the central bank’s inflation target because easy financial conditions stimulate spending, economic growth, and related inflation pressures. This rally in stocks may have prompted Powell to redraft a very public speech to economists in late August. He spoke about nothing else for eight minutes at Jackson Hole except for his resolve to win the fight against higher prices.
But sentiment related to how forceful the FOMC now needs to be may be shifting. Fed Vice Chairwoman Lael Brainard, joined by other officials, have recently hinted they are uneasy with raising rates by 0.75 points beyond next month’s meeting. In a speech on Oct. 10th, Brainard laid out a case for pausing rate rises, noting how they impact the economy over time.
Others that are concerned about the danger of raising rates too high include Chicago Fed President Charles Evans. Evans told reporters on Oct. 10th that he was worried about assumptions that the Fed could just cut rates if it decided they were too high. He felt a need to share his thought that promptly lowering rates is always easier in theory than in practice. The Chicago Fed President said he would prefer to find a rate level that restricted economic growth enough to lower inflation and hold it there even if the Fed faced “a few not-so-great reports” on inflation. “I worry that if the way you judge it is, ‘Oh, another bad inflation report—it must be that we need more [rate hikes],’… that puts us at somewhat greater risk of responding overly aggressive,” Evans said.
Kansas City Fed President Esther George also had something to say on this topic last week. She said she favored moving “steadier and slower” on rate increases. “A series of very super-sized rate increases might cause you to oversteer and not be able to see those turning points,” according to the Kansas City Fed President.
Others like Fed governor Waller don’t view steady 0.75% increases as a done deal but instead something to be reviewed, “We will have a very thoughtful discussion about the pace of tightening at our next meeting,” Waller said in a speech earlier this month.
The caution surrounding oversteering isn’t unanimous; at least one Fed official wants to see proof that inflation is falling before easing up on the economic brake pedal. “Given our frankly disappointing lack of progress on curtailing inflation, I expect we will be well above 4% by the end of the year,” said Philadelphia Fed President Patrick Harker.
The ultimate result is likely to come down to what Mr. Powell decides as he seeks to fashion a consensus. In the past, votes, while not always unanimous, tend to defer to the Chairperson at the time.
Take-Away
If, after the next FOMC meeting, the Fed is entertaining a lower 0.50% rate rise in December (not 0.75%), they will prepare the markets (bond, stock, and foreign exchange) for the decision in the moments and weeks following their Nov. 1-2 meeting. If this occurs, it could cause stocks to perform well just before election day and perhaps make up some lost ground in the year’s final two months.
Looking Back at September and Forward to the Fourth Quarter
September is behind us, and so are the first three quarters of 2022. Yet still, other than the U.S. dollar, there hasn’t been a moonshot in any major market or sector. September 2022 is best characterized by saying a few markets tried to get off the ground, but not unlike the Artemis rocket that was scheduled to go to the moon on September 3rd, the launches were scrubbed and are now on-hold. Maybe they’ll fly in October.
Below we look at the month behind us in stocks, bonds, gold, and crypto. We do this with confidence that they won’t all be grounded forever – and look to find clues as to how the final quarter of the year may treat investors.
Out of the four closely followed benchmarks, Nasdaq 100, S&P 500, Russell 2000, and Dow 30, there was no runaway index either massively outperforming or underperforming. During the second week in September, the indexes teased that they were ready for take-off after they strung together several consecutive days where they were each up 1%-3%.
Reasons for the bounce that week include that a few of the indexes were approaching a technical floor, through which they’d be considered in a bear market. Stocks rarely break through support levels on their first try. In fact, they often bounce by a large degree.
Adding to the stock market’s climb to as much as up 4% on the month were strong economic numbers, which gave some participants comfort that the economy is still producing jobs and will withstand the Fed’s withdrawing accommodation. Others saw the sign of strong numbers as a sign that the Fed would drive up rates, drag the economy into a recession, and then ease policy by bringing rates back down. This forward-looking reasoning had them bullish.
Eventually, as the month moved along and Jay Powell, the chairman of the Federal Reserve, continued reiterating the central bank’s resolve, stock market investors stopped fighting the Fed – from September 12th, until month-end, the indexes dropped between 12%-14%
The two standout sectors within the S&P 500 include Health Care which was least negative at down 1.90%, and Biotech, down 4.42%. While this performance doesn’t seem like something to get overly excited about, the dynamics which have taken these two only half as down as the broader index are worth looking into. Both health care and biotech had once been in the stratosphere during the early and mid-pandemic era. As the potential for further benefit waned, these segments fell from their stratospheric highs. Currently, there is potential as large pharmaceutical companies are flush with cash from the pandemic, sit with patents approaching expiration, and biotech, with fresh patents and current R&D on the next generation of medicine, running low on funds. These conditions are ripe for partnerships and acquisitions to accelerate between the two. This may include some individual biotech companies surprising investors with some very good news in the coming months.
On the weak side is technology, which also is still coming down from the pandemic-induced high. The index is down 11.09%. Utilities are also underperforming the broader indexes as higher fuel costs for electric companies and higher interest rates erode the attractiveness of dividends paid on these stocks.
Two non-equity assets, each claiming to be a safe haven during any market, political, or economic upheaval, outperformed the broader stock markets during September. Gold maintained its steady as she goes pace with very little volatility, while bitcoin had dramatic days on the up and downside, with each less than 3% lower than where they began the month.
Interest rates were the topic on everyone’s mind throughout the month. Government bonds are valued 3.48% less than they were at the start of September, with uncharacteristic volatility late in the month as markets first began to fear the worst and then reversed with the BOE announcement that it would resume a less restrictive and possibly easier monetary policy.
High-yield bonds more closely track equities (and even bitcoin) than the interest rate markets. These bonds of less creditworthy issuers spent almost half the month in the positive before underperforming treasuries, which were in the red for all of the month. Tips or inflation-indexed treasuries shed 6.89% for its investors. The securities are sold off a spread to a similar maturity treasury, so they will generally move in the same direction. The Fed holds on its balance sheet a large (as a percentage outstanding) of these securities, this has disrupted the bonds’ use as either a hedge against inflation or a gauge to see where the markets think inflation is heading.
A number of Fed governors spoke during the last week of September. They are united in their message that they are only just beginning to move monetary policy to a place where the economy is in a healthy situation where inflation isn’t eroding the dollar’s purchasing power. None have begun to hint that the policy statement from the November 2nd meeting will look any different than the last.
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.
Homeowners With Low Rates May Keep Inventories Low and Prices Stable
For many, the largest single asset they own is their home. While many investors are concerned about what rising interest rates may mean for investments in the stock market, homeowners are keenly aware that rates can directly impact home prices as most borrow to buy. The amount they can borrow is directly related to their cash flow, so the purchase price they can afford rises and falls with mortgage rates. This impacts demand and offer prices. But what does it do for the supply side of the pricing mechanism?
Rate Increases and Homes on the Market
Mortgage rates over the past year have risen from the low 3% range to the low 6% range for traditional 30-year loans. Typically the period in the rate cycle when mortgages begin to rise corresponds to a Fed tightening cycle, as it has in 2022. While rates were lower, buyers were able to afford “more house” and allowed sellers to push up asking prices – or in some cases, buyers would have had a bidding war driving up a home’s price.
As rates increase and it then costs borrowers more each month for the same price, buyers lessen. Home prices initially don’t decline as quickly as sellers would like as home sellers are stickier on the way down than they are on the way up. As with any investment, until you book your profit/loss, it’s just paper gains/losses. And homeowners don’t like to think of themselves as having “lost” thousands because their house once would have fetched more. So home buyers sit and wait, which in the past has caused inventories to increase. Eventually, there is capitulation among homeowners, and many houses hit the market with lower prices attached to them.
This has not happened yet during this rate cycle, and there is an underlying reason that may prevent it from happening. Existing homes are not entering the market as expected.
Homes for Sale are Scarce
The Wall Street Journal published an investigative piece on the real estate market and how Homeowners with low mortgage rates are stubbornly refusing to sell their homes because it would mean they’d have to borrow at much higher rates for wherever they may move.
The Journal reported that housing inventories had risen somewhat from record lows earlier in 2022. But this is primarily because they aren’t selling as quickly. The number of newly listed homes from mid-August to mid-September fell 19% from the same weeks last year. This suggests that those that may have sold to move for any reason are staying put.
The explanation for this unexpected phenomenon is that most that have purchased or refinanced their homes in the past few years have historically low mortgage rates. Imagine having 2.75% locked in for 30 years and knowing that if you purchase the home in the next town with the extra bedroom, your rate will be 6.25%. Potential sellers are opting to make do.
Homes will always enter the market regardless of dynamics. People die, change jobs, get divorced, the kids move out, etc. But, if those who have the option not to move decide to stay in larger percentages than in the past, it could keep the inventory of homes for sale below normal levels. The low supply could keep home prices elevated.
Another option someone who would like to move has is to rent. Rents have been quite high; this would serve to reduce the upward pressure on tenants. It would also keep homes from entering the market, allowing them to retain values better than might be expected with higher mortgage rates.
The scarcity of homes on the market is one of the primary reasons home prices have retained their high levels, despite seven straight months of declining sales in a period when interest rates have roughly doubled since December.
Handcuffed by Low Rates
There is a term used on Wall Street for employees that feel they can’t leave their company because they have vesting interests worth too much. For example, my friend Katherine was granted stock options from her company, the ability to exercise the options vested over a few years. At any point, if she left to take another position, or as she told me she wanted to do, raise children, she would have been leaving a huge sum of future stock or cash behind. Homeowners with mortgages near 3% when rates are near 6% have found their situation similarly handcuffs them and drives greed-based behavior.
Today Millions of Americans are locked in historically low borrowing rates. As of July 31, nearly nine of every ten first-lien mortgages had an interest rate below 5%, and more than two-thirds had a rate below 4%, according to mortgage-data firm Black Knight Inc. About 83% of those mortgages are 30-year fixed rates.
Can it Last?
Homeowners looking for more space are now more likely to add on than they had been before. For those looking to scale down, they may find that it isn’t worth it. In an analysis of four major metro areas—Atlanta, Chicago, Los Angeles, and Washington—Redfin found that homeowners with mortgage rates below 3.5% were less likely to list their homes for sale during August compared with homeowners with higher rates.
It is difficult to predict any market, and there is very little history to look back on when rates have been increased this quickly. Sam Khater, the chief economist for Freddie Mac, told the Wall Street Journal an analysis he did in 2016 of past periods of rising rates showed a decline in sales in which a buyers’ prior mortgage rate was more than 2% below their new mortgage rates. But there was no change if the difference between the rates was less than two percentage points. We are likely to retain more than a 2% margin for some time based on how low homeowners’ mortgages now are. Perhaps until many of the loans are paid off.
The Federal Open Market Committee (FOMC) voted to raise overnight interest rates from a target of 2.25%-2.50% to the new level of 3.00% – 3.25% at the conclusion of its September 2022 meeting. The monetary policy shift in bank lending rates was as expected by economists, although many have urged the Fed to be more dovish, others suggest the central bank is behind and should move more quickly. The early reaction from the U.S. Treasury 10-year note ( a benchmark for 30-year mortgage rates) is downward slightly, while the S&P sold off 26 points and the Russell 2000 remained unfazed. Equities later sold off as the Chairman held a press conference.
The statement accompanying the policy shift also included a discussion on U.S. economic growth continuing to remain positive. The FOMC statement said recent indicators point to modest growth in spending and production. Job gains were also seen as strong in recent months, and the unemployment rate remains low.
However, the statement points out that inflation remains elevated. The Fed believes this reflects supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures.
Russia’s war against Ukraine is causing tremendous human and economic hardship, according to the Fed. The statement indicated the inflation risks related to the is an area they are paying attention to.
Source: FOMC Statement (September 21, 2022)
The Federal Reserve made clear it was continually assessing the appropriate actions related to monetary policy and the implications of incoming information on the economic outlook. The Committee says it is prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede reaching the Committee’s goals. This is to include a wide range of information, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments, according to the statement.
Source: Federal Reserve Board and Federal Open Market Committee release economic projections from the September 20-21 FOMC meeting
Each member of the Federal Open Market Provides forward-looking assumptions on expected growth, employment, inflation, and individual projections of future interest rate policy. The table above indicates the range of expectations.
Take-Away
Higher interest rates can weigh on stocks as companies that rely on borrowing may find their cost of capital has increased. The risk of inflation also weighs on the markets. Additionally, investors find that alternative investments that pay a known yield may, at some point, be preferred to equities. For these reasons, higher interest rates are of concern to the stock market investor. However, an unhealthy, highly inflationary economy also comes at a cost to the economy, businesses, and households.
The next FOMC meeting is also a two-day meeting that takes place July 26-27. If the pace of employment and overall economic activity is little changed, the Federal Reserve is expected to again raise interest rates.
