Earlier last month the Dow Jones fell by 1,175 points and experienced its worst day in over six years and subsequently sent global markets into freefall. The return of volatility and early signs of inflation instigated uncertainty in the markets and consequently cancelled out months of steady growth. The main catalyst appeared to be fears of further interest rate hikes. So why exactly are rates expected to increase and what would be the broader effects of this decision?
Since the GFC, central banks around the world have been conducting expansionary monetary policy through large scale purchases of assets such as Treasuries and Mortgaged Backed Securities. This led to a sharp decline in interest rates with the US Federal Reserve System dropping rates from 4.5% to 0.25% and Reserve Bank of Australia reducing the cash rate from 7.25% to the current historical low of 1.50%.
In 2017 the Fed announced that the central bank would begin unwinding its balance sheets. By starting to sell their assets, they would begin a new cycle of contractionary monetary policy through three interest rate hikes in 2018. Indications of a resurgent US economy and strong domestic labour market seemed to be pushing inflation towards the target band of 2% - 3%. The decision was also reflected by other central banks such as the RBA, who despite immediately ruling out raising the cash rate, admitted that the next change would most likely be an increase rather than a decrease.
However, in early February a positive US jobs report exceeded market forecasts. The US economy created 200,000 new jobs in January - 20,000 more than forecasted. Wages also grew by 0.2%, putting annual wage growth at a 8 year high of 2.9%. This combined with the recent US business tax cuts and strong global growth prompted fears of higher prices (inflation) and speculation of more aggressive rate hikes. These developments affected three key areas - the stock, bond and the FX market.
The first big impact of the new data was a vicious selloff in the US 10 year bond market as investors expected future interest rates to rise. US 10 year treasury bond yields increased to 2.8% - up 0.4% since early January. Bonds in other countries also experienced a selloff with the 10 year Australian government bond moving past 2.90%. These changes also pushed the spread between the two bonds to an 18 year low of 2 basis points (0.02%).
The bond market selloff impacted the US equity markets. Tightening monetary policy through higher interest rates is beneficial if the economy is experiencing strong economic growth and there is evidence of sustained consumer spending. However, generally higher interest rates have a detrimental impact on consumer spending and investment. Coupled with rising wages, this would directly affect business costs and profits. Therefore, the main concern is not focused on the tightening policy itself, but rather the speed at which rates are being tightened and whether it would result in the economy slowing down significantly more. The fall comes after a long period of low volatility and strong company earnings growth pushed US stocks to all-time highs. A sharp correction was also felt in global equity markets such as ASX, JPX and LSE.
The volatility also moved into the FX market. Improved wage growth and strong economic data pushed the US dollar higher against all its counterparties.This is due to investors anticipating that there would be more than three Fed rate hikes, diverting money away from other countries and into the US. The Japanese yen also rallied to a five month high due to carry trade investors unwinding back their trades and their historical position as a net creditor and safe haven currency. Commodity export currencies like the AUD were hit the hardest. The AUD/USD ended the first week of February 2.3% lower at 0.7920c. This fall was also a likely result of the spread between the US and Australia 10 year bond yield falling close to negative – an incident which has only happened for 35 trading days since 1988.
This is because investors anticipated that there would be more than three Fed rate hikes, diverting money away from other countries into the US.
The first two weeks of February may have indicated that inflationary pressures are rapidly building and that the bears are overpowering the bulls, however this may not be accurate. While inflationary pressures are building, they are not increasing as fast as expected. The strengthening of the USD was short lived with other currencies pulling back after CPI results. Annual inflation still remains below target bands in the US, Australia and Europe. US stocks have recovered half their losses, leaving the S&P 500 up by 2% in 2018* and indicating that the long overdue correction may be over. What may be over is the almost decade long bull run in the bond market with US 10 year yields almost reaching 3%. Perhaps the pace of increase in interest rates are not so sudden after all.