Inflation in the rich world right now is at a multi-decade high. Interest rates are rising. Nonetheless, stock markets are still going strong. The question is: Why are equity markets not taking inflation and higher interest rates into account. How do we explain this dichotomy?
The interest rate on 30-year home loans in the US crossed 5% recently, the highest it has been in a long while. The primary reason for this rise has been the rise in US Treasury bond yields.
The yield on a bond at a given point of time is the annual return that an investor can expect if he buys the security and holds on to it until maturity. A Treasury bond is a financial security sold by the US government to finance its fiscal deficit.
The yield on a 10-year US Treasury bond as of 12 April stood at 2.83%, the highest it has been in more than three years. This explains why the interest rate on 30-year home loans crossed 5%. As Rupert Russell writes in Price Wars: How Chaotic Markets Are Creating a Chaotic World: “While the Federal Reserve set short-term interest rates, the long-term interest rates paid on mortgages, car loans and business loans were determined by the bond traders."
By buying and selling bonds at a certain price, bond traders determine the actual yield or return on a Treasury bond at a given point of time. Given that lending money to the government of a financially stable country is deemed to be the safest form of lending, the return that could be earned by investing in a Treasury bond becomes a benchmark for all other loans. So, as Treasury bond yields have risen in the US, so has the interest rate being charged there on home loans.
But why have Treasury yields gone up? Inflation in the US, at nearly 8% as last recorded, has been at a four-decade high. In order to control this inflation, the US Federal Reserve has decided to raise its key short-term interest rate, the federal funds rate. More importantly, it has decided to start taking out the money that it had printed and pumped into the financial system in the aftermath of the covid pandemic. The idea was to print and pump money into the financial system to drive down interest rates in the hope that people and businesses would borrow and spend more.
The minutes of the latest meeting of the monetary policy committee of the Federal Reserve reveal that America’s central bank plans to start withdrawing up to $95 billion per month from the financial system to start with. If this lasts for a year, more than $1 trillion could be taken out from the American (and thus global) financial system.
In the aftermath of the covid pandemic, the Fed printed money and pumped it into the financial system by buying bonds. This expanded the assets on its balance sheet. As of 1 January 2020, total assets on the Fed’s balance sheet stood at $4.17 trillion. Between then and now, its total assets more than doubled; as of 6 April, the figure stood at $8.94 trillion.
The Fed now has plans of selling these bonds at the pace of up to $95 billion per month and thus take printed money out of the financial system. This means that the amount of money going around in the financial system will go down. The US bond market is discounting this possibility already and Treasury bond yields have therefore gone up.
This is totally unchartered territory for the Federal Reserve as well as other rich-world central banks. By how much will interest rates go up as the Fed starts shrinking its balance sheet? Are central banks ready to let interest rates rise and perhaps even engineer a recession in order to control inflation?
The bond market clearly thinks so. But the stock market seems to be in a world of its own. Take the case of the Dow Jones Industrial Average, the US’s premier stock market index. It has fallen by just 5.7% since the end of 2021. This, despite the fact that the Fed has made it very clear that the era of easy money will come to an end, given that retail inflation in the US is at a 40-year high. The FTSE-100, based in London, has gone up by around 2.4% since end 2021, with inflation in the UK at a three- decade high.
So, how do we read all this? Typically, inflation and higher interest rates end up spooking stock markets. But that doesn’t seem to have happened this time around and markets have largely held on to the big gains they have seen over the last two years.
Do these stock markets think that central banks are bluffing? Do they think that at the first sign of any trouble, central bankers will be back to implementing the only monetary policy they seem to know? Flooding the financial system with money, that is.
If the history of the past few decades is anything to go by, that’s exactly what central bankers have done at every sign of significant economic trouble. Stock markets are probably discounting the expectation that central banks will be soon back to an easy money policy at the first sign of recessionary conditions.
Of course, given the complexity of the issue at hand, it is difficult to say anything definitive.
Hence, as far as stock markets are concerned, it may be a good time to go back to that old Gujarati saying that still rules Dalal Street: Bhav Bhagwan chhe (price is God).
Vivek Kaul is the author of ‘Bad Money’.
