Recent rise in yields and how it affects the Equity markets ?
The yield on the 10-year US Treasury climbed to 1.57%, a 72.5% increase year to date, which led to the selloff in the equity markets, particularly the high growth tech stocks.
To understand how this affects the financial assets, we need to look how these assets are valued. All financial assets are valued by discounting future cash flows to present at a discount rate determined by the yields. So if the yields go up, it decreases the value of these financial assets particularly those that have expected positive cash flows far in the future.
Rise in yields also denote higher interest rates, which means increased cost of borrowing for businesses. This will shrink the ability for businesses to generate greater profits, hence driving asset prices down.
Why do yields rise ?
There are mainly two reasons for the rise in yields. Firstly, the expectation of a strong economic growth, which is in line with the data from International Monetary Fund that suggests a 5.5% growth in global economy compared to a 3.5% dip last year.
Second reason is the expectation of a rise in Inflation. Inflation drives down the purchasing power of currency over time and hence makes financial assets like bonds less desirable, causing a selloff in bond markets which pushes up their yields.
However, on average yields have trended downwards and inflation has been at lower levels despite strong economic growth in the last few decades.
What explains this multi decade downtrend in yields and lower inflation rates and how will those factors play out?
Since the 1980s, there has been a strong Economic growth, however the yield was in a downtrend along with lower inflation in most of those economic cycles. To explain this, we need to look at the following factors and how they will play out in the future:
Effect of Fed’s Monetary policy: Interest rates have followed a continuous downtrend with rates being as high as 13.9% in 1981 to the current level of near zero interest rates. This continuous decrease in interest rates meant lower cost for financing and production which has been deflationary over the last 4 decades. But with interest rates already near zero levels and expected to rise in future, the reversion is likely to be inflationary.
Increase in Globalization: The past decades saw an increase in globalization, which meant the availability of cheap labour. Subsequently, this allowed the businesses to decrease their production costs which created a deflationary pressure. Now, with almost all economies interlinked across the globe and globalization being a key factor to that, ways to extrapolate further benefits are limited.
Advancement in Technology is another factor that has acted deflationary over the past decades. Most of the technological innovations have driven business costs lower. Innovation in technology will play out in the future also and will continue to act as deflationary.
Other factors that favoured this paradigm include Quantitative easing, Corporate tax cuts and Huge fiscal deficits.
When we look at these factors, most of them are extrapolated to an extent that it is difficult to derive more benefits and are likely to mean revert. Only innovation in technology remains a factor that continues to be deflationary.
What next? Can inflation rise?
Coming to the current dynamics, let’s understand how the Economy is positioned and what factors will drive the changes to it?
In the last 12 months, the Fed printed nearly 20% of all the dollars in circulation to fill the income hole that was created by business shutdowns and job losses due to the pandemic. A significant portion of this went to individuals savings account and many of them used this money to drive up prices of the financial assets like equities. As the Economy reopens, consumers will use these excess savings causing a release of pent-up demand which will likely drive prices of various goods and services higher.
Another simple way to look at this is that Demand for goods and services is going to increase in the coming months, but the dynamics of the supply side has not changed significantly, In fact there are supply shortages in areas like semiconductors and shipping which will cause inflationary outcomes. These factors are likely to drive up prices of goods and services and hence the inflation.
Understanding all the factors and current dynamics, it suggests that inflation will go higher, the only question is the rate at which it goes up and what will be achieved first, desired unemployment rate or a higher inflation and its implications on the Fed’s policy.
How will this affect the Fed’s policy?
The Fed has clearly stated that its priority is to decrease the unemployment rate from the current rate of 6.2% to pre pandemic levels of nearly 4.1% with a target inflation rate of 2%. The Fed plans to achieve this by its Monetary policy to keep interest rates lower at 25bps and by the Fiscal support from the Congress — a $1.9 trillion stimulus package is likely to be passed before March 14.
If significantly higher inflation is reached before achieving a desired unemployment rate of 4.1%, then it will create a dilemma for the Fed’s policy. Whether to increase interest rates to lower inflation which might exacerbate unemployment, or keep interest rates lower and let the inflation rise which might depreciate the value of Dollar — a reserve currency status that the US holds.
However, if desired unemployment rate of 4.1% is achieved before higher inflation is reached, then it will be a relatively easy situation for the Fed as it can increase the interest rates to tackle the inflation problem in this case.
