The Rules of the Game Are Changing for Investors
Rising U.S. bond yields have shocked financial markets out of their low volatility complacency. The fragile nature of last year’s Goldilocks-like environment of strong growth and easy money central bank policies has been exposed. The result has been a correction in equity multiplies and credit spreads from historically lofty valuations. Expect more to come.
The rules that investors have operated under for the last decade are changing. There’s greater confidence that the post-crisis era of ultra-low inflation is ending, and so is support from unorthodox Federal Reserve policies that suppressed market rates and volatility. Monetary policy is tightening at the same time fiscal policy is loosening. On top of that, markets have all the earmarks of late-cycle dynamics, such as excessive risk taking and financial leverage. The confluence of changing market, policy and fundamental dynamics is a game-changer for the risk cycle and asset valuations.
Fundamentally, the U.S. economy is growing above trend, led by strong domestic demand that has reduced the unemployment rate to 4.1 percent, the lowest in 17 years. The arrival of fiscal stimulus in the shape of aggressive tax cuts and ambitious infrastructure and defense spending plans will further fuel near-term cyclical strength. At the same time, the supply-side effects of the new fiscal measures on productivity and the economy’s long-term capacity for non-inflationary growth remain uncertain. This is not to say that the risk of a sudden inflationary shock has become a concern, but the prolonged period of subdued inflation is over, as is the need for crisis-era Fed stimulus.
This marks a fundamental change in the reflexive relationship between Fed policy and market stability. The steady decline in volatility and the cheap cost of leverage was a result of the quantitative easing measures employed by the Fed and other central banks. But as the Fed shrinks its balance sheet assets and normalizes rates, and as other central banks talk about doing the same, the primary reasons for the low volatility and the low bonds yields of the past decade are going away.
It's important to understand that the end of the low inflation era limits the Fed’s ability to support markets in times of excess volatility. That was underscored by the recent selloff in equities. As fears of accelerating inflation fuel expectations of a more rapid pace of monetary policy tightening, markets are now realizing that the bond cycle has turned.
The big question now is: How big of a negative impact will greater fiscal stimulus in the U.S. and the resulting increases in budget deficits and government borrowing have on the bond market, where investors have become accustomed to accepting negative term premiums? With the Fed reinvesting less of the maturing proceeds from its balance-sheet holdings back into fixed-income assets, it’s not hard to see the bond “vigilantes” make a comeback. The pricing of a return to more normal inflationary environment as seen in so-called breakeven rates implies that fair value for 10-year Treasury yields is above 3 percent, perhaps somewhere between 3.50 percent and 4 percent, compared with a recent 2.84 percent.
Higher market rates make it more expensive for investors to employ leverage. The unwinding of portfolio leverage adds to volatility, meaning a further hit to risk assets isn’t out of the question. Equity and credit valuations represent a delicate balance of fundamental cash flows, interest rates and volatility. As yields rise in line with a more normal environment, there is a direct impact on credit spreads and equity multiplies via higher corporate borrowing costs, higher market discount rates, a higher cost of carry and a higher cost of asset volatility hedging, even if -- or because -- growth stays strong.
With Fed policy normalization still in its infancy and with markets acclimating to the end of the “cheap leverage and low volatility forever” era, risk premiums will continue to adjust across all asset classes even though the peak in policy rates is likely to be lower than in past policy tightening cycles. Markets are at a critical point as the “global financial balance sheet” reprices. While investors search for the “new normal” in the cost of U.S. debt, expect more choppy price action across risk assets globally.
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