At the beginning of March last year, the spread of the new crown pneumonia epidemic in the United States showed signs of spreading. In order to prevent economic recession, the Federal Reserve provided all the tools during the financial crisis within one month and created a number of liquidity support tools in a targeted manner. Asset prices were the first to respond. As the anchor for global risky asset pricing, the yield curve of U.S. Treasury bonds sank across the board, and the yield of 10-year U.S. Treasury bonds was once as low as 0.5%. Zero interest rates and unlimited easing have helped U.S. stocks achieve a V-shaped rebound. At that time, the economic fundamentals were still in a quagmire of crisis, and the capital market had no concerns about policy withdrawal. Today, economic recovery has formed consensus expectations, inflationary pressure expectations have clearly risen, and policy withdrawal expectations have been put on the table. The Fed began to consider how to communicate with the market in terms of balancing economic recovery, financial stability, and the direction of monetary policy.
Note: This article was published in “China Securities Journal” on March 22, 2021.
Guan Tao is the Global Chief Economist of Bank of China Securities and a director of the China Chief Economist Forum
Soaring U.S. Treasury yields triggers market shock
After the Federal Open Market Committee (FOMC) meeting on March 17 this year, Fed Chairman Powell once again shouted to the market: short-term inflationary pressures and higher unemployment rates will keep monetary policy accommodative; there is still a gap before the asset purchase plan is cut. For a long time; will continue to pay attention to the rise in US Treasury yields.
The “dovish” of Powell’s words can hardly conceal the tendency of FOMC committee members to gradually increase interest rates. The “dot plot” shows that 4 of the 18 FOMC members hope to raise interest rates in 2022, while only one at the December meeting last year; 7 people think that they will raise interest rates in 2023, compared with only 5 in December last year. people. The next day (March 18), after the market digested the information, the Nasdaq index fell 3.02%, and the 10-year U.S. Treasury yield rose to 1.71%.
Since the beginning of this year, the rate of increase in the 10-year US Treasury bond yield has accelerated month by month, breaking through 1.1% at the end of January and rising to 1.44% at the end of February. As of March 19, it was an increase of 80 basis points from the end of the previous year. With the acceleration of US Treasury bond yields, coupled with favorable support such as vaccination and fiscal stimulus, the market style presents a typical re-inflation transaction. Year-to-date (data in this article are as of March 19), the Dow Jones Index, which is dominated by manufacturing companies, has risen 6.6%, the S&P 500 Index has risen 4.2%, and the Nasdaq, which is dominated by technology companies, has risen 2.5%. Although the Dow Jones Index is near its all-time high, the S&P 500 is down 1.5% from the year’s high, and the Nasdaq is down 6.2%. The dollar index has risen 1.6%.
In general, the rise in long-term interest rates and the economic upturn go hand in hand. However, there are divergent opinions on whether a market that has become accustomed to flooding liquidity can withstand the marginal convergence of monetary policy. Some believe that revenue improvement is expected to hedge the upward trend in interest rates. Others believe that historical experience shows that rising interest rates have led to inevitable stock market adjustments.
As the vane of global risk assets, the correction of US stocks triggered a global chain reaction. During the same period, the MSCI global stock index, developed country stock index and emerging market stock index fell by 1.4%, 1.1% and 6.8% respectively from previous highs. Rising interest rates in the United States will accelerate the return of the dollar, which is particularly detrimental to emerging economies that are still in the pandemic.
The Fed’s monetary policy adjustment becomes more difficult
Further disassembling the nominal yield, real interest rate and inflation expectations (break-even inflation rate) of the 10-year U.S. Treasury bonds since the beginning of this year, we can find the two-stage evolution law from the rise of inflation expectations to the marginal convergence of monetary policy expectations.
The first stage is from the beginning of the year to February 9. The rise in the nominal yield of US Treasury bonds mainly contributed to the rise in inflation expectations, and the real interest rate rose by only 2 basis points. At this stage, the FOMC continued its easing stance in January and will not react to the “short-term” increase in inflation. The market seems to believe that the current economic situation is in line with the Fed’s “average inflation target” meaning that monetary policy will not immediately respond to an appropriate upward trend in inflation. The Nasdaq Index also hit a record high on February 12th.
The second stage is from February 10 to the present. Inflation expectations have fluctuated within a narrow range between 2.2% and 2.3%, while the actual rate of return increased by 49 basis points, which basically contributed to all the increase in the nominal rate of return. At this stage, the US$1.9 trillion fiscal stimulus plan was passed smoothly, further strengthening the expectation of accelerated economic recovery. The market is beginning to debate whether the Fed needs yield curve control or distortion operations to suppress the upward trend of long-term interest rates or lower real interest rates. On March 4, Bill Dudley, the former chairman of the Federal Reserve Bank of New York, pointed out that the low yields of US Treasuries were unsustainable. In addition, commodity prices are rising like a rainbow, and copper prices have hit a 10-year high. The market is “vigilant” whether inflation will really become a “runaway horse” this time, and whether the Fed’s economic forecasts are too conservative.
The Fed’s policy logic is to use loose monetary policy in conjunction with a proactive fiscal policy to boost inflation expectations, thereby stimulating economic growth and helping the U.S. economy damaged by the epidemic to climb out of the pit. However, ultra-loose economic policies will encourage financial overheating. Once market inflation expectations are strengthened, U.S. Treasury bond yields will rise too fast, which may threaten the sustainability of the U.S. stock asset bubble blown by loose liquidity. As a result, the Fed has repeatedly emphasized that it is in a “wait and see” state, and that inflation expectations are not terrible, and substantive inflation will only take action. But the loophole of this logic is that the market will always rush away, especially the current valuation of US stocks is at the second highest level in history, second only to the Internet bubble in 2000. Disorderly exits are ultimately “chicken feathers in one place.”
At present, the market and the Fed have no disagreement on the upward trend of inflation. The low base effect last year and the high probability of fiscal stimulus this year will put inflation in a higher position in the second half of the year, and the market also recognizes that the Fed will accept the upward trend of interest rates on national debt. However, the Fed’s judgment on inflation is more based on a long-term perspective, and the reasons are roughly divided into three points: First, the demand side recovery is not yet complete, the real unemployment rate is high, and the monetary policy pays more attention to the demand side than the supply side; Second, the structural factors that curb potential inflation have not been reversed, such as population aging, shrinking employment, and high debt pressure. Third, the last economic cycle shows that the labor market is overheated and will not cause persistent high inflation. Employment priority ratio Inflation is more important. The U.S. market only recognizes one point, that is, after a significant increase in inflation, can monetary policy remain firm?
This view may evolve into three paths: the first is increasing upward pressure on inflation, U.S. Treasury yields have risen too fast, financial conditions have tightened before the Fed’s monetary policy, financial market turbulence, and the economy has turned cold. Subsequently, the Fed adopted a distorted operation or further loosened control of the yield curve; the second is that the upward pressure on inflation has increased, and the Fed has to act, and the financial market is turbulent, resulting in tightening of financial conditions and suppressing inflation in a two-pronged approach; the third is that inflation is in line with the trend. The Fed expects that the Fed will withdraw slowly and the financial market will pass the policy transition period stably. Of the three situations, the third is the ending that both parties are happy to see. But when interest rates go up, the market’s sensitivity and amplifier effect will become more prominent, making it more difficult for the Fed to communicate.
Test the Fed’s determination
Ultra-loose monetary policy is one of the root causes of financial instability. The low interest rate policy and credit bubble in the United States from 2001 to 2005 are vividly remembered. Buffett once said that when interest rates are low, stocks will be high, and vice versa. U.S. stocks are now floating high like they have lost gravity. Once the interest rate goes up too fast, the higher it floats, the more pain it will fall.
The U.S. Treasury bond yields have recently risen, and the market can still bear it. Although the S&P 500 Volatility Index (VIX) jumped to around 29, it was only about 1.4 standard deviations higher than the long-term trend value; the Ted Spread (i.e. 3-month LIBOR vs. 3 The monthly U.S. Treasury bond yield difference) is still only about 17 basis points, well below the long-term trend value of 47 basis points. Moreover, the current financial market financing interest rate is still lower than the level since the announcement of unlimited easing at the end of March last year, and some interest rates are even lower than the level at the end of last year.
Although the legal obligation of the Federal Reserve’s monetary policy is to stabilize prices and maximize employment, the Federal Reserve has repeatedly emphasized the importance of financial stability to the real economy. If money is blood, the financial system is the heart, and blood is sent to all parts of the real economy. The United States has a relatively high proportion of direct financing, and protecting the capital market means protecting American wealth. Whether or not to intervene in the short-term volatility of US stocks does test the Fed’s determination, but what makes the Fed even more entangled is how the future monetary policy withdrawal will neither pierce the asset bubble nor the debt bubble.
After the 2008 financial crisis, continued monetary releases have weakened the ability of American companies to clear out to a certain extent. Zombie companies that barely pay interest abound. This has also led to high debts in the US corporate and government sectors. If it is moderate inflation and higher income, it will help stabilize the leverage ratio of the corporate sector. However, if high inflation forces interest rates to accelerate upward, the debt pressure on the corporate sector will be unbearable.
In the 1980s, the Fed under Volcker’s administration “miracle” suppressed high inflation through high interest rates, and at the same time accelerated the recovery of economic growth. This time, the Fed may be ignoring the upward trend of inflation, hoping that inflation will naturally fall as expected, and finally successfully anchored at a position slightly higher than the target value of 2%. After all, US President Biden is committed to investing heavily in stimulating growth and needs to maintain a low interest rate environment, and Congress does not want to see the debt bubble burst and massive unemployment. As Fed Chairman Powell said, rising interest rates does not mean that financial conditions are tightening, and the loose monetary environment will continue.