In January of 2022 markets sold off as investors came to grips with the realization that the Fed was committed to end Quantitative Easing (QE), raise rates by March of 2022, and begin selling assets from its balance sheet. After years of “easy money” monetary policy, the Fed had been forced to change direction due to rising inflation worries. (1)
“The market is significantly overvalued, which works okay when interest rates are at record lows,” said Mark Zandi, chief economist at Moody’s Analytics. “But when rates rise, valuations become a real issue, so the market is adjusting to the new interest rate reality.”
To understand how this affects your portfolio and retirement savings a bit of historical context can be helpful.
So first… a history lesson…
In early February 2018 equity markets started to sell off. Volatility increased. On February 8th, 2018 the DJIA dropped over 1000 points.
Answer: The repricing of risk.
In 2013 the economy was still recovering from the Great Recession of 2008/2009 and was still fragile. A lot of economic data points showed contradictory trends. Believing the economy had sufficiently strengthened, the Federal Reserve announced it’s intention to start reducing its policy of Quantitative Easing which was put into place after the 2008 financial crisis and the Great Recession. Quantitative Easing was the government policy to buy US treasury bonds in order to keep interest rates low and support the economy. (2)
As a result of this policy bonds have had very low yields for several years.
This announcement resulted in a stock market reaction known as the “Taper Tantrum”. Equity markets declined over fear that the Fed would raise interest rates too aggressively and push the US economy back into recession.
As a result of the “Taper Tantrum” the Fed slowed its approach to reducing QE taking a measured approach that lasted 4 years before the Fed stopped purchasing assets and started to increase interest rates.
Fast forward to 2018…
The 2018 sell off in the markets occurred as the 10 year yield rose above 2.7%. As interest rates move higher, bond prices and bond values move lower.
What caused this to occur? The Tax Cuts and Jobs Bill of 2017 was finalized on December 19th, 2017. The tax cuts were largely unfunded and as a result economists, such as Tom Lee, Mohamed Elarian and Danny Blanchflower, expect larger deficits to finance the government going forward. This means more bonds being issued, more supply of bonds in environment where the the government has stopped buying bonds to support the price… As a result bond prices had declined and bond yield have risen. (3)
From Dec 18th, 2017 to Feb 8th, 2018 the following has occurred:
The 20 year bond yield had increased 18% from 2.55% to 3.03%. (4)
The price of the 20 year treasury (as measured by the value of TLT, the 20 yr treasury ETF) had fallen 7%. (5)
The US dollar has fallen 6%. (6)
Economists have called this the “repricing of risk”. As rates move higher it is possible that investors will sell bonds which are declining in price and instead buy other assets. As rates rise there is also a possibility economic growth could be hurt.
In 2018, Ira Jersey, Economist at Bloomberg news stated “it is rising rates and uncertainty driving the markets”. He continues by saying “the economy is strong and what’s happened in the past when there have been similar selloffs, the equity market finds a floor.”
In the time between 2018 and 2020 the Fed has engaged in quantitative easing and injecting cash into the currency markets. Because of this additional easy credit equities have been driven higher. Since 2017 the level of government debt in the US has increased $3 trillion and is currently running a budget deficit of $1 trillion/year. There was a fear of a recession or economic slowdown bond yields could move higher as more debt is issued… The greater the supply of something, the lower the price… and in the case of bonds, lower price means higher yields. (7)
With the advent of COVID in early 2020, markets responded by declining as economies were shutdown to halt the spread of the pandemic. As a result of fiscal and monetary policy, QE was expanded and rates were driven to zero. These conditions helped the economy recover quickly, but also led to a massive increase in asset values across all markets (equities, bonds, housing, commodities).
However, after a huge run up in equity markets in 2020 and 2021, several economic indicators have indicated a slowing economy. The Delta and Omicron variants impacted business that had strengthened over the summer of 2021. ISM manufacturing indicates slowing and possibly contraction through the spring of 2022. Because of this there is uncertainty about the economy’s health in January 2022.
As the Fed commits to raise interest rates and end quantitative easing in order to fight rising inflation (inflation grew to 7% in December 2021, highest level since the 1980s), the economy may be slowing or going into recession. (8)
From early December 2021 to mid-January 2022 the US 10 year yield moved up 26%. (9)
As a result, many fear a policy mistake by the Fed making things worse whether they raise rates too much or not enough. In January 2022 the NASDAQ declined over 16% at one point; the SP500 was down over 10%. Volatility reached levels last seen in the depths of the Great Recession. (10)
What does this mean for retirees? It is important to incorporate strategies that manage risk in your investment portfolios. Bill Gross, famed bond manager, has called this “the New Normal”. A period where markets exhibit volatility and limited gains.
If you are concerned by the current environment, please feel free to reach out to me at firstname.lastname@example.org . Learn how you can reduce risk going forward in an increasingly volatile environment.
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