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Moving into a Tighter Economy: Faster than Expected

“It may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated.” 2022 starts with some disturbing news for investors: on January 5th, minutes from the Federal Reserve officials’ December meeting were released. Within which, they suggested the possibility of withdrawing the support for the economy, tightening monetary policies through increasing the interest rates from potentially as soon as March, with a faster timetable than markets and central banks predicted. The minutes also showed that some officials raised the thought of shrinking the Fed’s $8.76tn portfolio of bonds and other assets after increasing the rates, aiming to further tighten financial conditions in the economy. The stocks fell sharply after the release of minutes, leaving many investors worrying about this year’s market performance.

Why at a faster pace?

The high level of inflation has been concerning from the end of 2021 and it is increasing with the potential risk of being out of control. The Personal Consumption Expenditure Index (which the Fed officially targets in its aim for 2% annual inflation) climbed 5.7% in November from a year earlier, the most since 1982. Meanwhile, rents are increasing more quickly, adding to the worries of more persistent inflation. 

Although there were policymakers hoping that inflation would fade back gradually with production starting to increase to meet the demand, tightening monetary policies became inevitable. By planning to raise the interest rates at an earlier stage, the Fed could avoid the possibility of businesses and consumers adjusting their behaviour to the high inflation, which has dominated the economy over the past year. Under those circumstances, it would be much harder for the Fed to control the price gauge, potentially forcing more drastic, and even recession-causing, rate increases in the future. 

Another contributing factor is the swiftly-healed labour market. Even though the issue of the labour shortage is still concerning, the unemployment rate dropped to below 4% and fewer long-term unemployed persons in the labour market indicate the sign of recovery. With the Fed’s primary goals targeting price stability and full employment, the very tight labour market has given more space for the Fed to tackle the high inflation.

Impact on markets 

When Fed officials indicated in December that they would expect to raise interest rates three times in 2022, the market’s response last month was muted. However, this time, in response to the publication of the minutes, investors reacted strongly to the reinforcement that higher interest rates were inevitable in the foreseeable future.  

The major stock benchmarks dropped sharply with the release. On January 5th, the S&P 500 fell by 1.9%, its biggest drop since late November. The blue-chip Dow Jones Industrial Average dropped by 1.1%. Meanwhile, big technology stocks took the largest hit with the tech-heavy Nasdaq composite falling by 3.3%, the worst one-day performance since February 2021. All five tech giants experienced a sharp decline in their share prices: Google’s parent company, Alphabet, dropped 4.6%. Microsoft fell 3.8%. Meta, Facebook’s parent company, fell 3.7%. Apple slid more than 2.5% and Amazon dropped nearly 2%.

This could be explained that when interests are higher, it becomes more expensive for companies to borrow, thus growth stocks tend to be more impacted as investors would regard uncertain future profits as less valuable relative to more guaranteed income from Treasury bonds. While tech stocks drove the majority of the gains in 2021, the rising interest rates could make them less appealing.

As for the government bond yields, the indicator of investors’ expectation of interest rates on 10-year Treasury notes soared up to 1.71%, the highest level since last April. Strategists from Morgan Stanley suggested underweighting U.S. Treasuries with the expectation of the 10-year Treasury moving past 2% by the end of 2022, while mortgage-backed securities would come under pressure from rich valuations and higher volatility.

The potential rise of interest rates could also end the era of inexpensive acquisitions. In previous years, the near-zero interest rates have made borrowing the billions necessary to finance an acquisition relatively cheaper. In 2021, $5.8 trillion worth of transactions were announced, but dealmakers are expecting a slowdown in 2022 with the interest rates being raised faster than expected and higher borrowing costs, which could deter some corporate boards from moving ahead with a deal.

What is in the future?

Interest rates were expected to increase. In November, with the projections released from the Fed meeting, most central bank officials predicted at least quarter-percentage-point rate increases, with half of the group expecting this increase to be implemented in 2023, or at the earliest in September 2022. However, the fast pace was unexpected, “But we do not think banks will abruptly set rates back to neutral, let alone into a restrictive stance”, commented by Morgan Stanley’s Chief Global Economist, Seth Carpenter, in Morgan Stanley’s 2022 Global Macro Outlook in December. At that time, he indicated his disbelief about any fast increase in interest rates, or any other extreme central bank measures that could slow economic growth. 

Nevertheless, the impact of rising interest rates in the market should not be overly concerned according to some central bank officials. “If inflation continued to ramp up, and there was some volatility on interest rates, that could have an impact,” said Stephan Feldgoise, Goldman Sachs’ Global Co-Head of M&A. But he quickly added that he believed this might not be a huge threat. “Would that have a dramatic effect, though?” he asked. “Debt’s still pretty cheap.”

Interest-rate derivatives suggested that investors think short-term rates would reach around 1.7%, while most Fed officials at their last meeting indicated that the rates would average 2.5% in the longer run. This could be reflected through the rising U.S. 10-year Treasury Notes yields up to 1.8% five days after the release. Yet rising yields are not all bad news. On short-term bonds, they are reflections of the Fed’s increasing rates, but on longer-term bonds, they signal confidence that those rate increases would not cause a recession, which was feared by many investors.

The largest risk remains the spread of the more contagious but seemingly less severe Omicron variant. While the Fed aims to tighten monetary policies with the assumption of a recovering economy, it is still questionable whether labour shortages, global supply-side frictions and other side-effects of the prolonged COVID-19 will be further exacerbated by the Omicron variant, as well as whether the economy will revive on its own amidst interest rate hikes.

Sources 

https://www.investopedia.com/fed-rate-hike-may-be-sooner-5215013

https://www.nytimes.com/2021/12/15/business/economy/inflation-fed-fomc-meeting-december-2021.html

https://www.nytimes.com/2022/01/05/business/economy/federal-reserve-minutes-interest-rates.html

https://www.wsj.com/articles/fed-minutes-reflect-growing-unease-over-high-inflation-11641409628

https://www.wsj.com/articles/global-stock-markets-dow-update-01-05-2022-11641374345?mod=djem10point

https://www.goldmansachs.com/insights/pages/outlook-2022-the-long-road-to-higher-rates.html

https://www.bloomberg.com/news/articles/2022-01-05/fed-leaves-gradualism-behind-with-urgency-on-rates-assets

https://www.morganstanley.com/ideas/thoughts-on-the-market-asia-equities

https://www.morganstanley.com/ideas/global-investment-strategy-outlook-2022

https://www.federalreserve.gov/monetarypolicy/files/monetary20211215a1.pdf

https://www.morganstanley.com/ideas/global-macro-economy-outlook-2022

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