AS CENTRAL BANKS are grappling with the worst inflation in a generation, reversing monetary policy over the last decade. This week, the US Federal Reserve hiked interest rates by half a percentage point and announced that it will soon be reducing its bond holdings. The Bank of Australia, which not long ago predicted it would keep rates near zero through 2024, surprised investors by raising rates by a quarter point on May 3. When we published our weekly edition, the Bank of England was expected to hike interest rates to their highest level since 2009.
Though stock prices have soared after the Fed’s rate hike – in apparent relief that it isn’t tightening more quickly – financial markets have painfully adjusted to the reality of tight cash. Global equity markets fell 8% in April and are down 11% in 2022 as investors discount higher interest rates and slower growth. On May 2, the US 10-year Treasury yield, which moves inversely with prices, briefly touched 3% (see chart), almost doubling where it started the year.
One consequence of the tightening of financing conditions is a revaluation of currencies. The dollar is up 7% against a basket of currencies over the past year. America needs higher interest rates than any other big rich country because of its overheated economy and job market. Higher interest rates in America are boosting investors’ appetite for dollars, increasing dollar demand caused by a drop in their desire to take risk elsewhere as war rages in Ukraine and China battles the coronavirus. Most notable was the greenback’s appreciation against the Japanese yen, the sole currency of a large wealthy country where interest rates are unlikely to rise anytime soon. In real terms, the yen has been the cheapest since the 1970s.
Another result is risk premium growth as investors worry about pitfalls in the new economic landscape. In America, the “inflation risk premium,” which rises when prices become difficult to predict, is at its highest level since 1994. Liquidity in the Treasury market appears to be draining. The spread on mortgage-backed securities over 10-year Treasuries has doubled year-to-date, reflecting concerns that the Fed may be actively selling its mortgage bonds. Corporate bond spreads have risen slightly as investors consider the possibility that higher interest rates will make it harder for companies to service their debt. And in Europe, the difference between what the German and Italian governments have to pay to borrow for 10 years has widened because tighter monetary policy risks making it harder for Italy to deal with its high debt.
A third effect is the poor performance of even diversified investment portfolios. In America, investing 60% in stocks and 40% in bonds produced an annual average return of 11% from 2008 to 2021, but has lost 10% this year. While 2021 marked the peak of the ‘everything rally’ that saw most asset prices rise, 2022 could mark the start of an ‘everything collapse’, with the end of low interest rates made possible by low inflation – the macroeconomic foundation for high investment returns .
While investors suffer, monetary policymakers may be tempted to change course. If they stopped raising interest rates and let inflation run hot, bondholders would lose money, but more inflation-proof assets like stocks and houses would benefit. The dollar would fall, which would help the many countries that have some exports or debt denominated in dollars.
Nonetheless, it is the duty of central banks, including the Fed, to respond to domestic economic activity and prevent inflation from remaining at unsustainable levels. Tighter financial conditions are the natural consequence of interest rate hikes, and adjustment still has work to do. Investors are still betting that US interest rates will peak at just over 3%. That may not be high enough to contain underlying inflation, which has risen above 5% by the Fed’s preferred measure. More pain to come. ■
Comments are closed.