Markets have been very volatile and the chain of events that are being played out has been very frustrating. Yesterday we had the biggest fall in markets for a single day for the year.
What’s happening? The Fed raised rates by 50 basis points for the first time in 22 years as was widely expected by the markets. The fear was that the Fed will raise rates next month by 75 basis points but Chairman Powell was quick to dismiss that. I had written earlier that the Fed is not going to raise by 75 basis points next month. So on the day of the hike, the market rallied but why did it fall more than it rallied yesterday? We can come up with many external factors like the Chinese pandemic resurgence and the Russian war situation. But there is one thing that is much overlooked by the major media.
There was a big move in the 10-year yield yesterday. It is the benchmark market-accepted interest rate, that is the basis for setting many consumer rates. It broke clearly above the psychological 3% yield and moved up 16 basis points which is a big move for a day. Mortgage rates went up to 5.27% which is the highest level since 2009.
Given that the Fed has now moved up 75 basis points, is a move above 3% in 10 years too steep? I don’t think so. The fear is that the rise of 50 basis is the beginning of a fast repricing of the trajectory of the rate. After all, Powell dismissed the fear that the Fed will take the Fed funds rate quickly to the neutral rate which is expected to be anywhere between 2% and 3%.
Currently, there is a 2% spread between the ten-year rates and the mortgage rates. There is also the same spread between the Fed funds rate and the ten-year rates. If the Fed is saying the neutral rate should be between 2% to 3%, then the ten-year rates should be moving to 4% or 4.5%. So why hasn’t the market moved to this level especially when the inflation rates are as high as 8.5%? It is because the government bond markets have been highly manipulated by the central banks.
Look what is happening in Japan. The inflation report on May 11th will be very critical. Frankly, it is only the Bank of Japan that is honest. They are not only in QE but they said they will be doing unlimited QE to maintain their yield curve control. After more than 20 years, there is still no serious inflation in Japan. They are still struggling with deflation.
The Fed, no doubt, is in a very tough position after they have announced openly about QT and interest rate hikes. Markets have started doubting the Fed’s dual mandates of price stability and full employment. For the last 14 years, the Fed did a fairly good job but cracks have started to appear now.
What can the Fed do? The Fed may not be able to handle this independently. But if there is one thing I have learned in my over 45 years in the markets is to never underestimate the collective resolve of the central banks. I really do not know what they will come up with. But they will do everything in their power to bring stability to the markets. Meanwhile, we will have to deal with a longer period of short-term volatility.
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Abraham George is a seasoned investment manager with more than 40 years of experience in trading & investment and multi-billion dollar portfolio management spanning diverse environments like banks (HSBC, ADCB), sovereign wealth fund (ADIA), a royal family office and a hedge fund. Currently, he is a co-founder of a new hedge fund where foreign citizens can invest in Indian growth stocks like Tanla operating in hyper-growth markets like CPaaS.