U.S. 10-Year Yields Rise Above 2.70% – 10 Questions on the Consequences of This Sharp Rise.
#10: Should you be afraid of the inversion of the yield curve?
As the weeks go by, one thing becomes clear to investors. They have probably underestimated the extent of the rise in interest rates. The yield on 10-year U.S. Treasury bonds has soared in recent days:
At 1.50% at the start of 2022, it rose above 2.80% on April 11, 2022, before falling back to 2.70% after high but expected inflation numbers in America for March 2022. They are already at the level that economists saw them at the end of 2022.
Such a rapid rise in rates raises many questions. Here are the 10 main ones with an attempt to answer each of them.
1. Does this abrupt rise in rates means a change of era in the markets?
This abrupt rise is at the center of investors' concerns. This is because the valuation of financial assets often corresponds to a discounting of future income. Thus, when interest rates rise, the world's stock markets, the debt of emerging countries, and corporate bonds are under pressure.
The U.S. bond market has never experienced such a sharp quarterly correction. Between January and March 2022, it lost 5.4%. For financial professionals, this is a real paradigm shift. They are more used to evolving in an environment of falling rates than rising rates.
Above all, they are navigating in a fog. Inflation has multiple causes. In addition to the excess of demand over supply linked to the end of the health crisis, there are other inflationary shocks that are difficult to quantify. Inflation in energy and food prices is likely to continue. And the shift from extreme globalization to regionalization will fuel price increases.
This is why central banks have been turning on a dime since the end of last year.
2. Are central banks, such as the Fed and the ECB, doomed to accelerate the inflection of their monetary policies?
The US inflation figure for March 2022 has again broken a record, 8.5% year-over-year:
In Europe, it also hit an all-time high of 7.5%. Central banks, therefore, have little choice. They are lagging in the fight against rising prices and must strike hard. The Fed has an ambitious program to raise its key rates. By the end of the year, they should be in a range of 1.75%-2%, compared with the current 0.25%-0.50%. A speed rarely seen before.
However, this will not be enough to bring down inflation. For that to happen, the Fed rate would have to reach 9.8%, which would have serious consequences for the economy. In the eurozone, the movement is also underway, but it will be even slower than on the Fed's side.
3. What strategy will the Fed adopt now?
At its last monetary policy meeting, the Fed showed its willingness to go faster in tightening its monetary policy, triggering the recent surge in U.S. rates. For the markets, all bets seem off.
Virtually everyone is now expecting a 50 basis point hike at the Fed's May 2022 meeting, and further hikes of the same magnitude in June and possibly July. At the same time, the Fed is expected to start reducing its balance sheet, which has approached $9 trillion after the Covid crisis. The goal is to withdraw $1.1 trillion per year. This could, in the medium term, cause the US 10-year rate to jump by 100 to 150 basis points.
4. Can the Fed tighten monetary policy without derailing growth?
The Fed has few tools at its disposal to try to ease inflationary pressures. It mainly plays on the level of interest rates: the higher they are, the more difficult it is for companies and households to finance themselves, which weighs on final demand. The effect is indirect and takes time to be reflected in the real economy.
For the Fed, the path is narrow. If it goes too fast, it could cause a recession. Indeed, 81% of Americans believe that America will be in a recession by the end of 2022.
But if the Fed doesn't do enough, inflation could become permanently high while growth would slow sharply, with the risk of stagflation, as America experienced in the 1970s. The Fed is well aware of these dangers, but its priority today is to fight inflation.
Interest rates are a blunt tool that will inevitably cause collateral damage. The Fed knows this and has already acknowledged it. While there is little doubt that the tightening of U.S. monetary policy will weigh on growth, the market is still hesitating between anticipating a soft landing or a real recession.
5. Why might the world's stock markets suffer from this rapid rise in interest rates?
Equity markets have benefited in recent years from low-interest rates and abundant liquidity poured into the financial system through the asset purchase programs of major central banks. When interest rates are low, investors have a strong incentive to move into equities.
Market strategists refer to this as the TINA effect, for “There Is No Alternative”. As bond yields rise, investors may return to bonds at the expense of stocks. Another danger comes from the high valuation of stocks. The lower the rates, the higher the present value of future profits. The continuous fall in interest rates over the past few years has therefore supported stock prices, especially for growth stocks such as tech.
6. Why do Tech and the luxury sector suffer more from the rise in rates?
On Wall Street, the technology-heavy Nasdaq index has already fallen by 10% this year, which corresponds to more than $1,000 billion in capitalization erased. If rates continue to rise, this correction could accelerate. Europe's stock market has a less tech-oriented profile, but it is not immune. Some highly valued sectors may also suffer from rising interest rates, starting with the luxury sector, which is the main driver of the Paris stock market, for example.
7. What contagion on European rates?
Since the beginning of 2022, American rates have dragged European rates in their bullish wake. However, the economic situation on both sides of the Atlantic is not the same. But this is the consequence of the central role played by the Treasuries market in the global bond universe.
By contagion effect, American rates set the pace for other rates. This is the case in Europe. At the same time, the yield on 10-year Treasuries has risen by 150 basis points, and the yield on German Bunds of the same maturity has risen by 90 basis points, i.e. a correlation of 70%.
8. What will be the consequences on the financing of companies?
Deemed risk-free, government borrowing rates constitute a floor below which corporate loans or bond yields cannot fall. The surge in government yields will therefore be accompanied by a mechanical increase in the cost of financing for companies.
Besides, several investors who had sought the yield offered by corporate bonds in a world of low sovereign rates will eventually turn away from this market and return to government debt.
Nevertheless, the danger is not imminent. Companies are generally healthy and have managed to generate strong margins. Moreover, they have taken advantage of the exceptional financing conditions before the rise in interest rates to strengthen their cash position. They can therefore wait several months before refinancing.
9. What could be the trajectory of the U.S. dollar in the event of a rate hike?
The consensus of economists and strategists established by the Bloomberg agency anticipates an overall decline in the dollar this year of 2.5% by September 2022 and nearly 4% by the end of 2022. The euro, below $1.09, would rise to $1.12 in 5 months and $1.13 by the end of 2022. The Fed will certainly raise rates, but it will be running behind much higher inflation, at 8.5% in March 2022, which will penalize the value of the greenback.
The markets expect the Fed to raise rates by 225 basis points by the end of 2022. In the United States, the new generation of citizens and executives is not ready to accept a new Paul Volcker. You know, the famous Fed governor who raised rates sharply in the early 1980s to fight inflation. For the Fed, 8% inflation seems to break down into a structural component of 3% and a transitory component of 5%.
In 1994, the doubling of interest rates in 12 months caused a resounding bond crash and a plunge in the dollar. This crisis is still remembered today and could lead the Fed to exercise some restraint.
10. Should you be afraid of the inversion of the yield curve?
At the beginning of April 2022, the US yield curve inverted. In other words, U.S. two-year rates exceeded 10-year rates. This is an anomaly since it is usually more expensive to borrow over a longer period. Investors, therefore, believe that it is riskier to lend to the government in the short term than in the long term.
Historically, when this double inversion occurred, the U.S. economy entered a recession the following year. But this time, the inversion of the curve owes much to the fact that the market's inflation expectations are, for very good reasons, very unusual.
Inflation should indeed remain high in the coming months, before the Fed's action brings it down. So we should not overinterpret this rate movement. Even if, more broadly speaking, not all danger of recession is over for the US economy. Far from it, as confirmed by a recent survey which indicates that 81% of Americans expect a recession by the end of 2022.
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