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Markets are still recovering from January’s US CPI (Consumer Price Index) i.e. annual inflation release coming in at a 39-year high of 7%.

Such ‘red hot inflation’, well higher than the US Federal Reserve’s target of 2%, has got the markets firmly looking at higher short-term interest rates this year. For the US, this means a higher key short-term ‘Fed Funds’ interest rate. This is the rate at which banks lend excess reserves to each other on an overnight basis at the Central Bank but more importantly it influences all other US interest rates.

Let’s re-cap – Higher interest rates are bad for stocks since

-higher interest rates make investing in bonds relatively more attractive versus stocks

-higher interest rates/bond yields raise the cost of corporate borrowing e.g. If Coca Cola has to issue a 10-year bond at 3% not 2% that directly increases their borrowing costs/decreases profitability.

-higher interest rates result in lower present day stock valuations as analysts discount future earnings using higher interest rates

Indeed, at the Federal Reserve’s 6-weekly FOMC (Federal Open Markets Committee) meeting on January 26 th the ‘Fed’ adopted a ‘hawkish’ tone indicating they were ready to move on interest rates as soon as need. Following the meeting, the markets were pricing in four 0.25% rises by the Fed this year. The current Fed Funds rate is 0.00-0.25% (it trades in quarter-point band).

Faced with the prospect of higher US interest rates US and global equity markets have had a tough start to the year with the S&P 500 down around 7% and the US NASDAQ technology index down just over 10% – both markets have been a few percentage points below this towards the end of January /early February.

Note how technology stocks have fallen more than ‘normal’ or value stocks. This is because technology growth stocks pay almost no dividends and so are more sensitive to interest rate rises compared to value stocks that pay healthy dividends.  

Two big pieces of news last week:

1) Meta, the Facebook parent company, fell 26% on Thursday wiping $225 Billion off the value of the company. This was on disappointing subscriber news. Both the S&P and the NASDAQ had their biggest one-day falls for a year (NASDAQ -3.7%).

2) The all-important US employment numbers (Non-Farm Payroll) were released. The markets were expecting 175,000 new jobs to be created and the number came in close to 500,000 showing the robust nature of the US economy. The Covid Omicron variant seemingly having little effect on service industry hiring.

This further increases the likelihood of higher interest rates this year and the markets moved to price in 5 x 0.25% Fed Funds rises from 4. Stocks were relatively unaffected (they don’t like higher interest rates but they do like a robust economy!) but bonds sold off with the 10-year US government bond going from a 1.80% Yield-to-Maturity to 1.90% – a sharp move indeed.

Perhaps valuation is the biggest issue for the US stock (and therefore global) markets* with the market US Price /Earnings Ratio (which compares share prices with the average of the past 10 years’ profits) being nearly 40 – more than double the historic average. Technology stocks even more so. Is there a trigger point where the level of short-term bond yields leads to a more calamitous fall in share prices? Only time will tell!

*Nothing in this article is investment advice.

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