It’s a new year, but last year’s problems—inflation and the Federal Reserve’s belated policy response to slow it—are battering stocks and bonds alike.
Treasury yields surged this past week, with the benchmark 10-year ending at 1.77%, equaling the high point it reached this past March. Shorter-term Treasury rates hit postpandemic highs as the market adjusted to the chance of three, and perhaps four, increases in the central bank’s key policy rate by the end of 2022.
Perhaps most important, the Fed not only will be winding down its securities purchases, which pumped trillions of dollars into the financial system, as previously announced. But minutes of the December meeting of the policy-setting Federal Open Market Committee released this past week, and comments by Fed officials, also heightened the chance that the central bank will begin to actually reduce its holdings, which would tend to drain liquidity and tighten financial conditions.
That prospect sent shudders through risk markets, notably technology and highly valued growth stocks. Discounting distant cash flows at a higher rate mathematically translates into a lower present value of that stream. In contrast, financial stocks, which tend to benefit from higher interest rates, were relative winners, along with cyclicals that look to deliver strong earnings growth in an economy that is expanding at a double-digit nominal rate, which includes the effect of rapidly rising prices.
That means the Fed has achieved one of its mandates: getting inflation to run above its long-run 2% target, to make up for previous shortfalls. And after the December jobs report was released on Friday, it could arguably declare “mission accomplished” on its employment mandate.
While the nonfarm payrolls increase came in light for the second month in a row at 199,000 (less than half the 424,000 forecast), the headline unemployment rate dropped sharply, to 3.9% from 4.2% in November and 4.6% in October. That puts the jobless rate just above the 3.5% trough reached in February 2020, right before Covid-19 broke out, and below the 4% that the FOMC estimates to be the long-run equilibrium unemployment rate, according to its most recent Summary of Economic Projections, released last month.
The proof of the labor market’s healing is in rising wages. Average hourly earnings and weekly earnings are up 4.7% from their levels a year ago. Over the past six months, average hourly earnings have risen at a 6% annual clip, “the best in decades outside of the Covid data noise in April/May 2020,” writes Peter Boockvar, chief investment strategist at Bleakley Advisory Group, in a client note.
Those pay gains aren’t keeping up with prices, however. The consumer price index is likely to clock in at a year-over-year rate over 7% when December data are reported this coming week.
Inflation is likely to remain elevated for five reasons, according to Evercore ISI. Those wage gains will probably accelerate; ditto for rents. Corporations also have “unprecedented” pricing power. And there’s “greenflation,” it adds. Just as addressing air and water pollution lifted inflation in the 1970s, addressing climate change is likely to do the same in this decade, according to the firm’s Friday economic note.
But the big reason is monetary stimulus. Evercore ISI calculates that the U.S. M2 money supply has increased an astounding 41% over the past two years. That’s more than twice the pace of monetary expansion following the financial crisis of 2008-09 and substantially greater than the money printing of the inflationary 1970s.
The Fed’s policy pivot looks relatively mild in the face of those inflationary forces. Its federal-funds target rate remains just above zero nearly two years past the crisis. And if there were three quarter-percentage-point hikes by year end, to 0.75-1%, that would still leave the real federal-funds rate deep in negative territory, even when measured against the Fed’s very optimistic projection that its favorite inflation measure (the personal consumption expenditure deflator, which invariably runs cooler than the CPI) will fall to 2.6% by the end of this year.
Nevertheless, the prospect of new Fed tightening conjures unpleasant memories of late 2018, when rate hikes and balance-sheet cuts sent the S&P 500 index tumbling just short of the 20% bear-market criterion. What was different was that the fed-funds rate, then 2.40%, was well above inflation and so was positive in real terms, about 0.5 of a percentage point above the CPI’s 1.9%.
Longer-term rates also ran above inflation, with the 10-year Treasury topping out around 3.25%—a positive 1.35% in real terms. Compared with a 7% CPI, the current 1.77% is deeply negative in real terms. The 10-year Treasury inflation-protected security, which is supposed to be priced off anticipated inflation in the coming decade, ended the week at minus 0.77%.
Read more Up and Down Wall Street: Top-Rated Bonds ‘Make No Sense.’ With 63 Years in the Market, Dan Fuss Should Know.
But perhaps the real market news is that the prospect of a less accommodative Fed lifted real interest rates, which in turn whacked risky assets. The 10-year TIPS yield was up 23 basis points on the week, while the five-year TIPS yield rose 28 basis points, to minus 1.33%. (A basis point is 1/100th of a percentage point.)
Not surprisingly, risk assets suffered, with the Nasdaq 100 of the biggest nonfinancial stocks slumping 4.5% on the week, its worst showing since last February. The uptick in real rates, albeit to still negative levels, was enough to take a bite out of financial asset prices. The question is whether negative real rates will provide the restraint to lower inflation, as the Fed expects.
Write to Randall W. Forsyth at email@example.com