1. Rise in US interest rates
Yes, at the last meeting the Fed raised the key rate by 0.25 basis points. The market even reacted positively to this, because everything was “in line with expectations.”
The market unconditionally believes the Fed. The fact that the Fed will cope with the current situation. And therefore refuses to notice the current problems that have become pronounced over the year.
- The problem of interest rates.
The real yield on 2–10-year US Treasury bonds is currently minus 5.5%. Negative returns. And it started last year. And here’s what’s interesting: historically, when real returns were negative, there was a surge in returns the following year. Moreover, often the increase in profitability was not due to a sharp decline in inflation. And because of the increase in rates by the Fed. An increase that the market did not expect. And now, Powell said that if necessary, the Fed is ready to raise the rate by 0.5 bp, and at the same time, we will soon see a reduction in the balance sheet.
2.What is balance reduction?
There is a US bond market. The price of bonds, like any other instrument, is formed according to the “demand-offer” principle. If there are more sellers, then the price falls; if there are more buyers, then the price rises.
The key point is that when the price of bonds decreases, their yield increases.
Simple calculation:
- Price — $1000, coupon — $50. Profitability — 5%;
- Price — $800, coupon — $50. Yield 6.25%.
- That is, the growth of bond yields indicates a sell-off in the debt market.
Bond rates are interconnected with all other rates. For example, if rates are low, then banks reduce interest on deposits. And it makes no sense for companies with a normal credit rating to take new money at higher interest rates.
Let’s say if the bond rate is on average 3–4%, then corporate debt should give a risk premium. Depending on the credit rating, this premium can range from 0.5% to 10% or more.
So if rates are near zero, it becomes cheaper for many companies to issue new bonds. And in 2020, the Fed did not just cut the key rate. She began to buy Treasury bonds from the market, creating artificial demand.
Increased demand = higher prices = lower rates.
Roughly speaking, the Fed “prints” new money and buys previously issued bonds from banks.
Thus, the Fed lowered real rates to a minimum and supplied liquidity to the system. There was a lot of money, and companies could raise huge sums for development at minimal interest. Naturally, all these bonds are “stored” on the balance sheet of the Fed itself. And this action has a side effect — a huge avalanche of money in the system, which causes inflation and the growth of the derivatives market. As a result, we get a colossal market growth, high inflation and a good percentage of GDP growth (although I would like more, but not all the money went into the economy).
So, at some point, the Fed will begin to unload this balance. That is, to sell bonds to the market, taking money.
Even now, the yields of 2–10-year bonds show an average of 2.3–2.4% per annum. What is most interesting is that a year ago this parsing was from 0.162% for two-year bonds to 1.6% for ten-year ones.
She became inverted. Two-years began to exceed 10-years.
And historically, the “inverse” curve was a harbinger of a recession in the US.
Let me remind you that the last reduction in the balance sheet was at the end of 2017, and in 2018 the market collapsed by 20%. At the same time, Powell said that the reduction will be more aggressive than before.
3. But can we really expect a recession and how soon?
In general, the growth of the market and the economy after the start of the pandemic was driven by low interest rates. It is very cheap for companies to attract new loans — they show high growth rates. Well, the market, since it primarily pays attention to growth rates, has dispersed many stocks to incredible prices.
And what is happening now?
Fed raised rates by 0.25%? But everything is much more interesting. Growth in bond yields over the past 3 months:
• 6 months old. The yield increased from 0.193 to 1.07. In fact, 5.5 times;
• Annual. Yield increased from 0.4 to 1.64. In fact, 4.1 times;
• Biennial. Yield increased from 0.73 to 2.39. In fact, 3.3 times.
How much do you think short-term loans have become more expensive?
Many companies that enjoyed tremendous popularity, but did not earn anything, this led to a collapse in capitalization even now. Beyond Meat (NASDAQ:BYND) (-75% of the maximum), Teladoc (NYSE:TDOC) (-75%), Fastly (NYSE:FSLY) (-70%) and many others. It even hooked one of the largest giants — Facebook (NASDAQ:FB). The decline in growth rates and forecasts led to a collapse of shares by 41%.
4. Problems only grow
Now the market for the most part is still holding on, although this year it is still trading in the red. Due to the fact that the Fed is still acting “within expectations”.
But the big question is, can the Fed handle the current situation?
Inflation is currently almost 8% per annum. And now it will be exacerbated by the colossal rise in energy prices. In the US, the price of gasoline rises weekly. In addition, the disruption of many supply chains, which have been exacerbated by recent events, will drive up prices in other industries as well. Therefore, even an increase in the key rate will not be able to bring down inflation easily and quickly. Because the main problem lies, as I said, in supply chains and energy resources.
And here, probably, the market can come to disappointment. Now he believes in the Fed. But what if the Fed raises the rate to 1%, or even to 1.25% by the summer, and inflation is high at the same time? Or will it get even higher? This will provoke the growth of yields, raising the real yield of bonds. And this, in turn, will hit the entire economy. High interest rates, which, in fact, will show a multiple increase compared to last year, will greatly slow down business development.
And as we know, the price is based on the expectation of growth rates. A decrease in these growth rates will lead to a decline in the market. Examples are already in front of your eyes.
I don’t know when exactly this will happen, because in the current global situation, all factors, especially in the future, cannot be taken into account. But the graph of the yield curve shows that it has already become inverse, and short-term yields are growing much faster than long-term ones. There is a possibility that it will become completely inverse. And yet the US has tens of trillions of junk debt. That is debt with a low credit rating. A huge number of companies that do not even earn anything. For them, it will be a huge problem to increase rates and reduce optimism in the market. Not all of them will survive the coming crisis. This is by the way that the US is now proud of the recovery of the labor market and unemployment. True, unfortunately, the reality behind these words is very shaky.
5.What to do?
To say that medium-term longs in the US stock market have died is not, because there are still companies and sectors there that look promising:
- First, it is the semiconductor sector. With supply chain disruption and semiconductor shortages, some companies are showing efficiency gains despite rising manufacturing inflation.
- Secondly, it is the banking sector, which will benefit from spreads between loans and deposits as rates rise.
- Thirdly, these are insurance companies. There are very few insurers that maintain a positive operating balance, but nonetheless some are selling at a discount due to the pandemic.
However, in the current situation, a reduction in the share of US assets in favor of emerging markets suggests itself:
For example, the same China, which has already announced its intention to increase the rate of GDP growth and support the economy. A country that now shows low inflation and has “room for maneuver”, unlike developed countries.
But in this case, given the situation in developed markets, diversification and revision of the strategy is no longer a whim, but a necessity.
6. Gold
Gold is a great tool that protects during times of uncertainty. At times of rising inflation, it practically does not show itself in any way. But at a time of growing tension in the world — excellent.
There is no point in making a big bet on gold this year. Although you need to understand that if there is a panic sale in the US market, then the demand for gold will increase.
