After January’s wild ride, expect more volatility
Falls in bond and equity prices that followed the Fed’s hawkish pivot may just be the start, with the key test still to come in new issue markets.
A common story from sell-side analysts paid to encourage investors to keep pouring money into financial markets is that credit performs well in the early stages of an interest-rate hiking cycle because corporations benefit from strong economic growth.
It became apparent last year that the US Federal Reserve had fallen far behind the curve on inflation. Extraordinarily loose monetary policy and helicopter money delivered from the government to laid-off workers led to high demand for goods that supply chains, stressed by lockdown restrictions, could not meet. Prices rose sharply.
The Federal Open Market Committee’s (FOMC) hawkish pivot revealed in the minutes of the December meeting and confirmed at the January press conference now has those analysts predicting anywhere between four and seven interest-rate hikes this year and balance-sheet reduction of anywhere from $500 billion to $1 trillion in 2022.
The key battle will come elsewhere, on the same ground where it is always fought…
The financial market sell-offs came fast: 10-year US Treasury yields shot up at the start of January and two-year yields at the end of the month. The Nasdaq entered correction territory, at one point down more than 10% from all-time highs at the end of 2021 as investors applied higher discount rates to the future cash flows of growing tech companies and put a lower net present value on them.
Equity volatility in the final week of January was extraordinary, with modest end-of-day moves disguising wild intraday swings of 4% and more.
Even bitcoin, the supposed inflation hedge, collapsed, falling 20% through January.
What of credit, the supposed safe haven?
Moves were less dramatic, maybe, but not good. The yield on the S&P500 global bond index rose from 2.28% at the start of January to 2.69% at the end, handing investors a 3% loss for the year to date. The high-yield bond index was down 2.72%.
There is a chance that the Fed can yet salvage its credibility if supply constraints ease, demand falls from US consumers that have spent the government’s bounty and inflation falls back in the second quarter. Economists know, of course, that changes in monetary policy do not transmit so quickly. But FOMC members may quietly cling to the hope that their once-derided and now abandoned description of inflation as transitory proves correct. They could still look good.
Pain and panic
However, a battle will now play out, albeit one never acknowledged in FOMC minutes or statements. Does the Fed really manage and respond to the economy, or rather to financial markets? How much pain will the FOMC allow investors to suffer before its members panic once more and ease financial conditions?
A 10% fall in equity markets is not pain and neither is a rise in 10-year US Treasuries to 2% or even to 2.5%. The Fed will hope that the US Treasury can compensate for the central bank's absence as a buyer of long-duration government bonds by issuing more short-term bills. Money-market fund reform might help here by increasing the bid for government paper of less than one-year maturity.
The key battle will come elsewhere, on the same ground where it is always fought. If sharply rising risk-free rates coincide with widening credit spreads and growing fears of recession and impaired debt-service capacity, then watch the primary debt capital markets closely.
Treasurers and banks can cope with new issue windows that open and shut. However, if they remain closed for a long period and if high-yield – but most especially investment-grade – corporates should struggle to refinance maturing debt and to raise new money, that is when the Fed may pivot again back to accommodation.
Let’s hope it doesn’t come to that. But it might.