Friday's Market Minute: Higher Rates Meet Higher Volatility

This post contains sponsored advertising content. This content is for informational purposes only and not intended to be investing advice.

Extreme bearishness is typically a buy signal for stocks, but the bears are firmly in control. Faced with the prospect of multiple interest rate rises, slowing economic growth, bearish consumer sentiment, and inflation at multidecade highs, investors continue to skew equity allocations away from growth companies in hopes of insulating their portfolios from the ongoing market correction. The Nasdaq, which typically leads the broad market in both directions, has now fallen 12.7% from a record struck in November. It’s no coincidence that the Fed also accelerated the wind-down of quantitative easing around the same time.

Markets are trying to negotiate the impact of three forms of monetary tightening. Tapering slows and ultimately ends the expansion of the Fed’s balance sheet. After tapering is done, the Fed still maintains the size of its balance sheet by rolling over maturing bonds into purchases of new bonds. Balance sheet runoff is different from tapering of asset purchases. In this case, the Fed would not reinvest bond principal re-payments from maturing Treasuries, and remit profits back to the U.S. Department of Treasury. The last time the Fed began to reduce its balance sheet was in late 2017, and 2018 was a rough year for stocks. Outright quantitative tightening, or selling of bonds into the market, is unlikely, but the probability of a hike in the overnight lending rate is a near certainty in March. Using the CBOE 13-week Treasury Bill yield index as a proxy for Fed activity, the IRX has increased from 25 basis points at the end of 2021 to nearly 170 basis points yesterday. Long-term rates are also rising, but the yield curve is flattening, spooking equity investors.

In just a few weeks, Wall Street has gone from pricing in a gradual tightening of policy to a sprint that could perhaps deliver 4 to 5 rate hikes this year. It is possible that to combat inflation the Federal Reserve will need to raise interest rates at a faster pace and by a larger magnitude than previously anticipated. Inflation and interest rate concerns are going nowhere soon, and there is reason to think that expectations of shrinking the Fed’s bond portfolio and raising rates will impact liquidity, which matters most to stocks and other risk assets.

Image sourced from Unsplash

This post contains sponsored advertising content. This content is for informational purposes only and not intended to be investing advice.