A sharp rise in interest rates weighed on bond and equity markets last week as market participants assessed the potential for tightening financial conditions in the year ahead. The 10-year U.S. Treasury yield surged to close the week at 1.77% from 1.51% at year end. High growth stocks in particular were hit hard as their values are tied more to future cash flow potential than to current earnings power, causing them to be more sensitive to changes in rates. Meanwhile, cyclical sectors—like energy, financials, and industrials—have rallied and helped dampen overall market volatility. For the week, the Dow Jones mostly held its ground dipping by just 0.3%, while the S&P 500 fell 1.8% and the tech-heavy Nasdaq Composite tumbled 4.5%. The rapid rise in long-term rates also dealt sharp losses to long-term bonds with the 10-year U.S. Treasury note losing 2.13% last week, while the 30-year Treasury note fell even further with a 4.91% loss.
Behind the recent back-up in yields and repricing of long duration assets are growing expectations that the Federal Reserve will need to accelerate its policy pivot toward tightening financial conditions to rein in excess liquidity and stubbornly high inflation. Last week’s employment report and the release of December’s Fed meeting minutes seemed to further confirm a quicker pace of tightening and added fuel to the rise in rates. The released Fed minutes showed growing consensus among meeting participants that a quicker lift-off in rates and a reduction in the central bank’s balance sheet may be warranted. Friday’s employment report then bolstered the case for quicker lift-off as it pointed to tight labor market conditions with the unemployment rate ticking down to just 3.9% and wages growing 4.7% year-over-year, well above the pre-pandemic rate of around 3%.
As a result, expectations for rate hikes in 2022 have rapidly reset from only two rate hikes anticipated a little over a month ago to closer to four hikes today. According to the CME FedWatch tool, rate markets now reflect an 85% probability of a March rate increase. The timeline for reducing the Fed’s balance sheet has also been brought forward, which would have the effect of reducing demand for long-term bonds as the Fed steps away from the market. It would also gradually pull reserves from the banking system that are available to be lent out. In other words, the Fed is looking to slowly pull away the punch bowl of liquidity, which has been a support for elevated financial market valuations.
However, though liquidity may be peaking with the pivot in policy, excess liquidity isn’t going away any time soon. And although real yields are improving, they remain at depressed levels. As a result, inflows to equity markets have remained steady with another $25.6 billion added to equities in the week ending January 5th, according to a report from Bank of America. That comes on the tail of a record $949 billion of net inflows to equities in 2021, exceeding the cumulative net inflows of the past two decades. Our team will be watching risk assets closely as well as the Federal Reserve’s communications as they seek to navigate this transition, and we will keep you apprised of developments and our perspectives.
The week ahead will be a busy one with a host of important economic readouts as well as the start of the fourth quarter earnings season. On the economic docket, the most anticipated reports will be an update on inflation with the release of the December consumer and producer price index readings (CPI & PPI) as well as the retail sales report that will show how consumer spending finished out the year. Friday will then kick off earnings season with several large banks scheduled to report. Analysts are expecting a strong finish to 2021 with a consensus forecast for 21% year-over-year growth in earnings for the S&P 500 in the final quarter, according to FactSet.
Next week, please lookout for the release of our annual publication, The Long View, with reflections on an eventful 2021 and our perspectives as we look to the year ahead.