The ten questions raised by the rise in interest rates

Sent April 13, 2022, 6:15 am

Weeks go by and one thing becomes clear to investors. They probably underestimated the magnitude of the rise in interest rates. The yield on 10-year US Treasury Bonds, the central benchmark for global markets, has soared in recent days. At 1.50% at the beginning of the year, it exceeded 2.80% on Monday evening, before rising to 2.70% after high inflation values ​​but in line with expectations. They are therefore already at the level where economists saw them at the end of 2022. Overview of the main issues raised by such a rate hike.

1- Is it a change of era in the markets?

This sharp rise is at the heart of investor concerns. For good reason, the valuation of financial assets often corresponds to a discounting of future income. Therefore, when rates rise, global equity markets, emerging market debt or corporate bonds are under pressure. “The US bond market has never undergone such a sharp quarterly correction. Between January and March, it lost 5.4%, “comments Franck Dixmier, Global Head of Bond Management at Allianz GI. For financial professionals, this is a real paradigm shift. They are more used to evolving in an interest rate environment. Above all, they are sailing in the fog. Inflation has multiple causes. To the excess demand on supply linked to the end of the health crisis, other inflationary shocks have been added that are difficult to quantify. ” energy and food products should last. As for the transition from extreme globalization to regionalization, it will fuel the rise in prices “, continues Franck Dixmier. What explains the turnaround on the wing operated by central banks since the end of last year.

2- Are central banks set to accelerate the movement in the face of rising inflation?

The US inflation figure for March again broke a record 8.5% in 12 months. In Europe it also hit an all-time high of 7.5%. Central banks therefore have little choice. At an advanced stage of the fight against price rises – until last November they presented inflation as a transitory phenomenon – they must hit hard. The Federal Reserve, in particular, has an ambitious plan to raise its key rates. They should evolve at the end of the year in a range between 1.75% -2% against the current 0.25% -0.50%. A speed almost never seen. However, emphasizes Stéphane Déo, Ostrum’s director of market strategy, this will not be enough to really lower inflation. This would require Fed rates to hit 9.8%, which would have serious consequences for the economy. In the euro zone, the movement is also ongoing, but it will be slower.

3- What strategy will the Fed adopt?

In its latest monetary policy meeting, the Fed showed its willingness to act faster in tightening its monetary policy, triggering the recent US rate hike. For the markets, the game seems to be done. “We expect an increase of 50 basis points [au lieu de 25 pb habituellement, NDLR] at the May meeting, and other similar increases in June and possibly July, ”Franck Dixmier anticipates. At the same time, it should begin to reduce its balance sheet, that is, stop reinvesting the amounts of bonds in the portfolio that have reached maturity. Also, if that’s not enough, sell stocks on the market. The goal is to withdraw $ 1.1 trillion a year from a budget that was close to $ 9 trillion after the Covid crisis. This could, in the medium term, raise the US 10-year rate by 100-150 basis points.

4- Can the Fed tighten its monetary policy at such a pace without derailing growth?

To try to ease inflationary pressures, the Federal Reserve has few tools. It mainly affects the level of interest rates: the higher they are, the more difficult it is for businesses and households to finance themselves, which weighs on final demand. The effect is indirect and takes time to reflect in the real economy. For the Fed, the path is narrow. If it goes too fast, it could cause a recession. But if this were not enough, inflation could anchor at a perpetually high level while growth slows sharply, with the risk of finding itself in a context of “stagflation”. The Fed is well aware of these dangers, but its priority today is to fight inflation. Interest rates are a “brutal tool” that will inevitably cause “collateral damage,” said Christopher Waller, a member of the US Central Bank’s Board of Governors. While there is little doubt that tightening US monetary policy will weigh on growth, the market is still hesitating between anticipating a soft landing or a full-blown recession.

5- Why could global equity markets suffer?

Equity markets have benefited in recent years from low interest rates and the abundance of liquidity poured into the financial system through asset purchase programs of major central banks. When rates are low, investors have every incentive to get into stocks. Market strategists speak of the “TINA” effect: there is no alternative. As bond yields rise, investors could turn back to bonds at the expense of equities. Another danger comes from the high valuation of the shares. The lower the rates, the greater the present value of future profits. The continued decline in rates in recent years has therefore supported stock prices, especially growth stocks such as tech.

6- Why do tech and luxury goods suffer more than others due to rising interest rates?

On Wall Street, the tech-tinted Nasdaq index has already dropped 10% this year, which equates to over $ 1 trillion in capitalization written off. If the rate hike continues, this correction could accelerate. The stock market Europe has a less tech oriented profile, but it is not immune to it. Some expensive sectors could also be affected by the rise in interest rates, starting with luxury, the main engine of the Paris Stock Exchange.

7- What contagion on European tariffs?

Since the start of the year, US yields have led European yields in their uptrend. However, the economic situation on both sides of the Atlantic is not the same. In particular as regards the nature of inflation, deriving from an overheating of the domestic economy in the United States, while it is much more “imported” in the euro area, because it is closely linked to the surge in energy prices. But this is the consequence of the central role played by the Treasury market in the global bond universe. As a result of contagion, the American tariffs give the “la” to the other tariffs. This is the case in Europe. “At the same time, the yield on 10-year Treasuries increased by 150 basis points, and that of German Bunds of the same maturity increased by 90 basis points, which is a correlation of 70%,” stresses Franck Dixmier.

8- To what extent does this make corporate financing more expensive?

Deemed risk-free, government borrowing rates constitute a minimum level below which corporate loans or corporate bond yields cannot fall. The surge in public yields will therefore be accompanied by a mechanical increase in the cost of financing for businesses. Furthermore, a number of investors who had sought the yield offered by corporate bonds in a world of low sovereign rates will eventually turn away from this market to return to government debt. However, the danger is not imminent. The companies are overall healthy and have managed to generate high margins. In addition, they took advantage of the exceptional financing conditions before the rate hike to strengthen their cash position. They can then wait several months before refinancing.

9- What trajectory for the dollar in the event of a rate hike?

The consensus of economists and strategists established by the Bloomberg agency predicts an overall decline in the dollar this year of 2.5% by September and nearly 4% at the end of the year. The euro, below 1.09 dollars, would rise to 1.12 dollars in 5 months and to 1.13 at the end of 2022. The Federal Reserve will certainly raise rates but will run after much higher inflation, at 8.5% of March, which will penalize the value of the greenback. Markets are pricing in a Fed rate hike of 225 basis points by the end of the year. “In the United States, the new generation, citizens and decision makers, are not ready to accept a new Paul Volcker [NDLR : le gouverneur de la Fed qui releva fortement les taux au début des années quatre-vingt pour lutter contre l’inflation]. For the Fed, inflation of 8% appears to be breaking down into a structural component of 3% and a transitional component of 5%, “said Stephen Jen, strategist at Eurizon SLJ Capital. In 1994, the doubling of interest rates in 12 months resulted in a resounding collapse in bonds and a collapse in the dollar – a crisis that has remained in everyone’s mind and which could encourage the Fed to do some restraint.

10- Should we fear the inversion of the yield curve?

Leave a Reply

Your email address will not be published.