The Fed is raising rates as fast as it can, and the Treasury yield curve is flat or inverted. Is this a bad scenario for US banks? Not right now, since the rates banks pay on deposits have risen much less than rates on Treasury bills or the fed funds rate, as is often the case. And wider credit spreads on corporate loans have also helped improve lending margins. Our stock rankings show higher readings for the Financials sector, helped by strong earnings estimate revisions, particularly in mid- and smaller-cap banks and thrifts. Readings above zero on the chart below indicate analysts raising estimates more in Banks than in the overall US market, and recent readings have been far above average.
The stock market has rallied sharply since mid-July, while long-term bond yields have been stable to lower. Even the mighty US dollar has paused a bit in its uptrend. But inflation remains high (though likely peaking) and Fed officials continue to say they will continue to raise rates (and reduce the balance sheet) well into next year. The old market adage says “don’t fight the Fed” (i.e., be cautious when the Fed is tightening policy, and more aggressive when they are loosening), but it looks like markets have in fact been rallying in spite of the Fed lately.
Yesterday’s decision by the Federal Reserve to raise rates by 75 basis points for a second consecutive time was historic, as it marks the most aggressive back-to-back rate hikes (150 basis points in less than two months) since the early 1980s, before the Fed was formally targeting the fed funds rate as its key policy focus.
The Fed’s statement and press conference yesterday clearly indicated that the Fed is not done with raising rates yet, but gave some of the first indications that they are acknowledging the signs of slowing economic growth and that the lagged effects of the rate hikes to date have not been fully felt yet. Markets reacted favorably to the news (75bps was well anticipated before the meeting), as it brings the potential for smaller rate hikes and the eventual end of the rate hike cycle closer.
Equities, and asset prices in general, have seen a return of volatility during January, following over a year of very subdued volatility and strong returns. Why, especially in a historically favorable seasonal period? In our view, markets are adjusting to the indications of moderately tighter monetary and fiscal policy following a period of extraordinary support from both US macro policy drivers. Investors are debating whether policy makers will be able to reduce stimulus and inflation pressures without provoking excessive economic weakness, and this debate is showing up as volatility in markets.
Macro uncertainty is provoking volatility
Central bank policy remains a key focus for investors as rates are set to rise in the US this year, with debate about the pace of the rate hikes and balance sheet adjustment ongoing. However, this is not true everywhere, as there have been growing divergences in expected rate policies among the major developed market central banks.
As shown in the chart below of two-year sovereign bond yields for the US, UK, Japan, and Germany (Eurozone), investors are pricing in multiple rate hikes over the next year or two from the US Fed and the Bank of England (BoE): US and UK two-year yields are at or near 1% now, up from around zero for most of the time since early 2020.
Fed Chair Jerome Powell testified before Congress on Tuesday alongside Treasury Secretary Janet Yellen, and markets were listening. While many topics were discussed, the markets responded most to Powell’s indication that the Fed may speed up the recently announced tapering plan for the huge bond buying program (“QE”) that has been in place since March of last year. The initial plan for $15 billion/month reductions in bond buying would have brought the process to a close by June of next year, while a faster pace could do so by March. Markets also focused on Powell’s comment that the word “transitory” may no longer be applicable with regard to inflation: “it might be time to retire that word (‘transitory’) and try to explain more clearly what we mean.”
Inflation remains a hot topic among investors, policy makers, and voters. While there is not a great deal that policy makers (fiscal or monetary) can do in the short term to control inflation (today’s announcements of coordinated releases from strategic oil reserves are mostly a signaling action), there are steps that can be taken on a longer horizon. Monetary policy has historically been the primary lever used to try to manage inflation, though it has arguably been less effective in recent years as it has run into the “zero lower bound” (ZLB) with short-term interest rates. Fiscal policy is likely a more potent lever but historically has not been used as such.
The bond market has clearly awoken from what appeared to be a low-volatility Fed-induced slumber for much of last year. Longer-term bond yields in the US and elsewhere have jumped to their highest levels since just before the COVID crisis hit markets early last year (blue line in first chart below). Even after this rise, though, the 10-year Treasury yield remains below even the low points of previous cycles.