As interest rates rise around the world to combat significant inflation bond yields in both short-term (i.e. 2-year bonds) and medium-term (i.e. 10-year bonds) have risen sharply. Indeed, the yield on the US 10-year Treasury note, in the first couple of days of May, touched 3 per cent last week for the first time in more than three years, as traders prepared for the Federal Reserves to raise interest again to combat soaring inflation.
The yield on the government bond has profound effects on the economy, feeding into home mortgage rates and borrowing costs for companies: The higher the yield, which rises when bond prices fall, is tightening financial conditions after two years of the pandemic.
Yields have risen this year as the US central bank takes action to stem US inflation, which is a hot 8.5% on an annual basis in March, its fastest rate of increase in 40 years. A similar picture exists in the rest of the world.
The combination of high inflation and a weakening global economic outlook has raised questions about how far the Federal Reserve will be able to lift interest rates without overburdening the economy. The Fed faces a ‘thick slew of uncertainties’, including rising labour costs, supply-chain problems and commodity prices that have risen during Russia’s war in Ukraine.
Indeed, at the FOMC meeting of May 4th the Fed raised in key Fed Funds rate by 0.50% to a new range of 0.75% -1.00%. This is the first time the Federal Reserve has done more than a 0.25% move since 2000 showing they ‘mean business’. As short-term US interest rates go up the key Fed Funds rate is now expected to be close to 2.5% by the end of 2022, up from last week’s 0.25-0.50%.
The combination of gloomy economic data (slowing activity growth in the Eurozone and US factory sectors) and rising bond yields is weighing on global stock markets which have fallen 10-15% so far this year.
Higher interest rates support a currency of course and the US Dollar DXY index, which measures the US currency against a basket of six other currencies, is sitting just below its 20-year high.
The end of the good times?
Of course, for years financial markets have benefitted enormously from the generosity of easy monetary policy (low interest rates) in a world economy deemed by central banks, and the US Federal Reserve particularly, to lack sufficient aggregate demand. To the detriment of markets, this has been changing rapidly as central banks, belatedly recognise that today’s problem is not one of weak demand but, rather, insufficient supply.
Central Banks felt compelled to maintain ultra-loose monetary policy in a world of muted economic growth. The Fed went further and, in August 2020, shifted to a new monetary framework that postponed the usual policy response to inflation nearing and exceeding its two per cent target.
For markets this translated into abundant liquidity and sky-high asset prices. So, the Fed has taken its foot off the liquidity pedal and asset prices have fallen including a 13.3 per cent fall in April alone for the more interest rate sensitive growth stocks of the US NASDAQ stock market (think Apple, Netflix, Tesla etc…).
External headwinds are also a worry. China’s stubborn adherence to a “zero-Covid” policy is undermining both its global demand and supply roles. Europe is also slowing and could well fall into recession should there be a significant disruption in gas supply because of the war in Ukraine.
Policymakers will need a rare mix of skill, luck and time to soft land both the economy and the markets.