The knee-jerk market reaction to the Fed minutes this week was very much a ‘Lions, tigers and bears, oh my!’ situation. The sudden realisation that there are potential dangers out there, but in reality, things may not be that bad – yet. The market had become used to the idea of a faster pace of tapering the Fed’s bond purchases, and had even taken the Fed’s forecast of potentially three rate hikes in 2022 in stride. It was the notion that the Fed could run off some of the holdings sooner than expected (Trump’s ‘quantitative tightening’, everybody else thinking that it was a step to a return to normalcy) that seemed to knock sentiment on Wednesday. Can the market hold up in the face of higher real yields?
Charts, charts, charts
For the purpose of this blog, a few charts will save lots of words. The idea for these came from our Chief Economist, John Calverley, and the charts and comments that he prepares for our monthly investment committee meeting, but I tweaked them a touch for this blog.
The top chart is a simple Fed funds less CPI (Y/Y) monthly chart, along with the monthly S&P 500 price close in a semilog form to reduce the ‘straight line up’ problem a bit. This chart suggests that on this measure of real yields, they can bump along above zero for some time before stocks tumble. Remember, real yields can turn positive by the Fed pushing rates higher, and/or by inflation falling. So if the CPI rate falls to 0% Y/Y by late summer, for example, and Fed funds are at 0.50%, real rates will be positive, right?
The next chart expands the real yield concept further by showing Fed funds, the 2-yr. note yield and the 10-yr. note yield all less CPI (Y/Y) vs. the S&P 500. This chart pretty much shows the same thing, positive real yields can be seen for some time before the stock market slumps.
The bottom chart is old faithful – the coupon curve (10-yr. note yields less 2-yr. note yields). This has nothing to do with real yields, but in general as the Fed pushes short rates higher (over which they have a lot of control) at some point the 2-yr. note yield (anchored to these) crosses above the 10-yr. note yield and inverts the curve (below zero). This is usually taken as a sign that sentiment on growth has soured, and tough times are ahead for stocks.
As 2022 kicks off, lets keep in mind that there are a lot of scary things out there, but put them into context. Higher real yields, will, over time, potentially be a worry. Right now? Not so much. And keep an eye on ‘old and trusted’ barometers as well, just in case.