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On Thursday, March 17, broad-based equity markets in the United States ended the day in positive for the third consecutive session. This included the Nasdaq (+1.33%), S&P500 (+1.23%), and DJIA (+1.23%).
Participants in equity markets continue to believe that Russia-Ukraine peace negotiations will continue to progress. The Federal Open Market Committees (FOMC), which decided to raise interest rates, was the biggest news in the U.S. fixed income sector.
The FOMC increased rates by a quarter percent point this Wednesday; although expected, the move officially signals a tightening of monetary policy.
It is widely believed that there will be six additional hikes this year and three more in 2023. With the Treasury yield curve flat, the fixed income market has been planning for such a move for some time.
Curve of Treasury yields (Author)
Why not raise rates right away?
The Federal Reserve’s dual mandate is to ensure maximum employment and long-term price stability. The focus has been on reducing inflationary pressures, as the job market is now back to pre-pandemic levels.
Annual US CPI changes (Author)
The Fed has increased rates in the past to stop broad-based price rises that eat away savings and consumer purchasing power. Other rates, such credit card, auto, and mortgage rates are affected directly by the Fed Funds Rate increase.
In order to make borrowing more expensive, producers and consumers adjust their spending habits which leads to price adjustments.
Fed funds rate (Author)
We can see in the chart that the Fed lowered the Federal Funds rates to help jump-start the American economic recovery from recessionary periods. This caused asset prices to rise to almost breaking point.
In these periods of recession, asset prices have fallen to the point where the Fed lowered the interest rate to a level that allows the American consumer to open up their pockets again.
COVID-19 has caused a recession that is fundamentally different from other downturns. However, excessive stimulus, consumer demands, and unforeseen chokepoints in the global supply chain have all led to similar economic problems.
We have already seen a significant rise in mortgage rates after Wednesday’s Fed rate hike. Freddie Mac stated that mortgage rates have increased to over 4% for the first-time in nearly three years.
The market is already cooling down due to the expectation of an increase – the National Association of Realtors reported that existing home sales fell 7.2% to their lowest level since August 2021.
The spread of 10-two Treasury yields is an accepted indicator for a recession. Market participants are no longer motivated to invest in longer-dated securities, as short-term securities offer the same yield and similar risk.
The 10-two Treasury yield fell 59.5% this year, and is currently hovering around 0.31%. As we approach zero, the market will prepare for a market contraction which normally occurs within three years.
US Treasuries and Fed Funds (Author)
Lipper Classification Flows
The top three Lipper classifications in January were Multi-Cap Core funds (+$11.3 trillion), Loan Participation Fonds (+$10.5 trillion), and U.S. Government Money Market (+$9.5 million).
These three types represent equity diversification and the prediction of future rate increases. They also represent a strategic reallocation to short-term securities. Large-Cap Growth Funds (-$16.5billion), High Yield Funds (+$11.5billion) and S&P 500 Index Funds (+$9.8billion) were the top outflows.
In a rising rate environment, growth and high-yield investments are in trouble. Technology and growth issues must now factor in a higher borrowing rate to their heavily debt-ridden financials. High-yield bonds are less attractive if investors can get the same yield on the open markets for less credit risk.
The top three Lipper classifications in February were International Income Funds (+$31.8billion), S&P 500 Index Funds +$30.9billion, and Large-Cap Value Funds (+1.83 billion).
In February, investors gravitated towards financials to diversify their equity holdings. Financial institutions will be able offer more loans to customers now that interest rates are higher. Unfortunately, saving rates do not usually increase as quickly.
The top three inflows this week were from U.S. Government Money Market Funds (+5.4billion), Multi Cap Value Funds ($3.1billion), and Commodities Precious Metals Funds ($1.3 billion).
The top three most outflows from equity or fixed income categories were High Yield funds (-$1.6 billion), International Large Cap Growth (-$1.5 trillion), and S&P 500 index funds (-$1.5 million).
Inflation can not only affect sitting cash but also fixed rate coupon payments. Commodities will continue to attract flows over the next weeks.
Editor’s Note:Seeking Alpha editors chose the summary bullets of this article.
