We Love the 80’s, Just Not the Inflation
Stock and bond markets are off to an inauspicious start to 2022. Along with higher volatility and declines to stock markets, bonds haven’t seen returns this poor since the early 1980s when inflation was running rampant and the 10-year treasury rate was higher than 15%.1
The major contributor to stock and bond market headwinds this year is higher-than-expected inflation coupled with rising interest rates. The 10-year treasury rate went from 1.514% on December 28, 2021, and touched 3.066% on May 6, 2022.2 This is a significant rate move in a historical context and has important implications not just for bonds, but all assets. The relationship between bonds and interest rates is inverse. When interest rates rise, bond prices decline. But not all rate rises are equal. The speed at which rates move has an important impact on markets. Faster rate moves give markets less time to react, and repricing of assets can be sharper and more severe than if the moves were more gradual.
Why have rates moved higher so quickly this year? The simple answer is “The Fed.” The Federal Reserve is behind in combating inflation, which is the highest it’s been since 1980, and is trying to scale back monetary easing and raise rates to lower inflation before it moves even higher.
To say that markets were caught off guard by the speed of the Fed’s policy tightening would be an understatement. To illustrate this, we’ve included the market-implied probabilities of various rate hikes for the upcoming 12/14/2022 Federal Open Market Committee Meeting. These probabilities are calculated by the CME Group, which tracks trading in financial instruments tied to Fed Funds Rate expectations and helps illustrate how investors view the trajectory of interest rates.
At the end of 2021, markets projected there was a 0% chance that the Fed Funds Rate would be 2.25% to 2.50% or higher by the 12/14/2022 meeting. As time has progressed, we’ve seen market expectations for Fed policy shift significantly. As of 5/2/2022, based on the Fed Funds futures market, investors are now expecting a 100% probability that the rate is at least 2.25%.3
In addition to raising rates, the Fed is also planning on trimming their $9 trillion asset portfolio. If their plan moves forward, this will put further upward pressure on rates and create headwinds for many financial assets4 as they unwind their portfolio.
In terms of what this means for markets going forward, we expect both stock and bond markets to remain volatile and for interest rates to move higher as the fed continues to tighten policy. In this case, certain assets, such as stocks and bonds with high interest rate sensitivity, will likely struggle. Specifically, we may see growth-oriented stocks that have performed very well since the COVID outbreak in 2020 to mean-revert as markets reevaluate companies and favor profitability and positive cash flow to future growth potential. The below chart illustrates the benefit of incorporating both in portfolios over the last several years and further reinforces our position to have diversified exposure to stocks over market cycles. Additionally, incorporating assets that are less correlated to interest rates might make sense for portfolios, depending on risk tolerance and liquidity needs.
The period of easy money policy implemented by the Fed since the Financial Crisis is, in our opinion, coming to an end. This means that markets will remain volatile as investors sift through these changes and reposition portfolios. Ultimately, we feel that a world with more normal rates and where investors determine the value of assets without central bank intervention will be one with unique opportunities and will ultimately be more sustainable for global markets.
Recessions will happen and markets will be volatile – these are certainties. However, our viewpoint is that by holding a diversified portfolio that matches risk tolerance and making rational decisions that are focused on long-term goals, investors can improve their likelihood for success and weather periods of volatility like we’re seeing.
1“Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity,” FRED, May 6, 2022, https://fred.stlouisfed.org/series/DGS10/.
2Journal, Wall Street. “TMUBMUSD10Y | U.S. 10 Year Treasury Note Historical Prices – WSJ.” The Wall Street Journal. Dow Jones & Company. Accessed May 6, 2022. https://www.wsj.com/market-data/quotes/bond/BX/TMUBMUSD10Y/historical-prices.
3“CME Fedwatch Tool: Countdown to FOMC – CME Group.” Countdown to FOMC. Accessed May 6, 2022. https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html.
4Timiraos, Nick. “Fed Prepares Double-Barreled Tightening with Bond Runoff.” The Wall Street Journal. Dow Jones & Company, May 6, 2022. https://www.wsj.com/articles/fed-pre-pares-double-barreled-tightening-with-bond-runoff-11651397402?mod=article_inline.
Past performance is no guarantee of future results. All investing is subject to risk, including the possible loss of money you invest. Fluctuations in financial markets could cause declines in the values of your account. There is no guarantee that any particular asset allocation will meet your objectives.