Okay, so things have not been going well over the last week in the equity and bond markets.
The sell-off in the U.S. and non-U.S. interest rate markets worldwide—and the ensuing sell-off in the equity markets—have been quite noticeable and disconcerting.
The Fed has not been driving the recent sell-off
The prospect of higher interest rates and a steepening yield curve are clearly issues to worry about. But before we let them overwhelm us, it’s worthwhile to make sure we truly understand the drivers of this market dislocation and whether they are likely to persist. Further, and perhaps even more importantly, we need to figure out whether the proverbial “long-term pivot” (i.e., a pivot toward higher long-term yields) in the global rates markets is upon us. That pivot has significant implications for the near- and medium-term health of the equity markets.
First, contrary to assertions by many commentators, the primary driver of this sell-off in U.S. interest rates is not the Federal Reserve (Fed) or any potential moves the Fed may make in September or later. To understand why, consider the front end of the yield curve, which traces short-term maturities and reflects the likelihood of interest rate hikes: It has barely moved in spite of the significant sell-off in long-term U.S rates. Currently, the front end assigns to future rate hikes a probability of roughly 20%, which is low. And the last thing the Fed would want—and need—to do is surprise a recalcitrant market. Personally, I would assign virtually zero probability to the likelihood of a rate increase in September, notwithstanding the wish of JPMorgan Chase CEO Jamie Dimon.
Further, U.S. economic data is actually softening relative to expectations rather than strengthening. Thus, I still believe that even a rate hike in December is not in the cards.
So, if the Fed isn’t to blame for recent volatility, who is?
Look to Japan
The finger should be directly pointed to the Bank of Japan (BOJ) and other Japanese policymakers, in my view. Their recent pronouncements about quantitative easing (QE) and issuance preferences, which come ahead of the BOJ’s meeting later this month, are a deliberate attempt to steepen the Japanese yield curve—and the attempt has succeeded. Additionally, in an interconnected bond world, where cross-border flows are the primary determinant of long-term interest rates, the steepening of the Japanese yield curve has translated into a steepening of the U.S. curve.
If this assertion is indeed correct, the implication would be quite significant: It would mean that we are not at a long-term-pivot point in rates globally. Japan is still very much mired in structural disinflationary pressures (current cyclical conditions notwithstanding), and the BOJ will be pursuing QE for a very long time.
What investors should remember
There are other points to keep in mind:
- Despite the current sell-off in rates, interest rates remain extraordinarily low overall—and yield curves are extraordinarily flat.
- As I mentioned, the world’s global interest rate markets remain very interconnected—and global bond flows are the equalizer. This interconnectedness validates the “international concerns” that Fed officials—including Fed Governor Lael Brainard—have been citing for a while as a reason to hold off on raising interest rates, even if U.S. economic conditions reach a point that would tempt the Fed to do so. If the Fed were the only central bank to hike rates while others were still easing (as the European Central Bank and BOJ are likely to do), the resulting strength of the dollar would end up killing the modest growth rate of the largest economy in the world. And therein lies the paradox: If the Fed thinks that the U.S. labor market is strong enough to justify a rate increase, you can be sure that the labor market won’t remain that strong in the immediate aftermath of such an increase.
- While interest rates and equities may seem like they have the same directionality, don’t count on this directionality to persist. In other words, short-selling interest rates to hedge your equity or credit exposure may work for the short term but is unlikely to be a winning strategy over the long run. If equities continue to decline, then at some point we would expect U.S. rates to change direction and start rallying again.
- Monetary policies of central banks, which appear to be focusing on steeper yield curves—rather than on negative interest rates—are a significant benefit to the financial sector, which is the new “low-volatility” sector, in my view.
Finally, central bank policymaking is still the markets’ primary driver, whether we like it or not. And markets are no closer than they have been, at any point during the recovery, to accepting the proposition that easy monetary policy simply does not work today. They will probably continue rejecting this proposition for some time to come. And the pivot toward permanently higher interest rates is a prospect that is still years away from happening, in my view.
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