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After a short-lived rally earlier this spring, U.S. equity markets are reeling again. Does this latest round of volatility reflect more of the same concerns that have haunted investors so far this year?
It’s still very much tied to the U.S. Federal Reserve’s tightening policy, although the Ukraine War also remains a factor. The Fed has come a long way from saying, “We’re not even thinking about thinking about raising rates,” early last June. The question now is how far from here the U.S. central bank will go to get inflation back under control. Of course, investors aren’t completely in the dark. The Fed’s “dot plot” targets a short-term funding rate well above 2.5% by sometime next year, but it’s still a debate whether the Fed should be aggressive about reaching that target or take a more measured approach.
For instance, based on the Fed’s most recent guidance, investors can expect interest rates to climb by 50 basis points at each of the Federal Open Market Committee’s next two meetings in June and July, but as big as those moves would be – especially on the heels of two rate hikes totalling 75 basis points already this year – some market participants are acting as if that won’t be enough to curtail the rate of inflation, which, in the U.S., remains stubbornly high despite signs in April that some price increases are beginning to wane.
In fact, there’s an argument to be made for even bigger rate hikes in the short-term. Remember, the Fed immediately cut its funding rate by 100 basis points at the beginning of the pandemic and had started cutting rates well before that – albeit for different reasons. So, if the goal now is to normalize rates, why not increase them just as dramatically to get them back to where they were before all of this began?
Yet, herein lies the problem. If the Fed gets too aggressive, it runs the risk of slowing the economy too fast and by too much, therefore causing a recession. At the same time, there’s no guarantee that aggressive rate hikes in the short term are the cure for higher inflation today. No matter what the Fed or other central banks do, the Ukraine war still rages on and continues to impact energy and food prices around the world. Moreover, while supply chain disruptions seem to be easing, it will take time for them to abate completely, especially in an economic climate still somewhat at the mercy of the pandemic, as evidenced by the most recent lockdowns in China.
Needless to say, it’s a very difficult environment for investors to navigate. And it could be months still before we know if the Fed and other central banks are striking the right balance in trying to fight inflation without having the economy collapse. In the interim, it is important that investors pay attention not only to what central banks do in the weeks ahead, but also to what they say. As we’ve learned in the past few weeks, this is particularly true in the U.S., where Fed members regularly communicate their individual policy opinions, some of which could differ from “party lines” just enough to create further uncertainty about the direction of interest rates – even despite what ends up happening next.
Quantitative tightening (QT) is another indication of how quickly monetary policy has shifted over the past year. In fact, the U.S. central bank’s most recent quantitative easing (QE) program – which was put in place at the start of the pandemic to create liquidity in markets and hold rates low through bond purchases – only ended in March. But now, just a few months later, the Fed has an aggressive plan in place to go in reverse. Specifically, it is no longer a buyer of U.S. Treasury bonds and mortgage-backed securities, but a seller of these securities with the purpose of reducing its QE-inflated balance sheet, which has reached almost US$9 trillion in assets.
In effect, the Fed – via QT – will be tightening monetary conditions above and beyond what it plans to do with interest rates going forward. Yet that doesn’t mean QT will simply magnify the potential outcome. If anything, quantitative tightening may end up being less of a risk than investors believe and could even soften the blow of higher rates.
As a case in point, the Fed ended its first QT program in 2019 because it caused a crisis in overnight lending markets; however, a repeat of that scenario seems unlikely given the Fed now has an overnight-lending facility in place to ensure banks have sufficient access to cash, no matter the liquidity backdrop they must deal with going forward.
Moreover, while QT could dampen economic growth – much like higher interest rates will do – it’s also possible that it helps prevent the economy from falling into a recession. After all, quantitative tightening is likely to result in higher yields for longer-dated maturities as large bond sales pressure rates higher. In turn, that could reduce the risk of another inverted U.S. Treasury yield curve sometime in the future, which, if it can be prevented, may end up being crucial to the health of the economy.
Credit, don’t forget, is necessary to help finance future growth, and banks largely make their money by borrowing short term at low rates from depositors and lending longer term at higher rates. So, the steeper the yield curve remains, the more incentivized the banks are to lend and the greater the chance that a more serious slowdown in the economy can be avoided – at least for the time being.
Ultimately, investors should expect equity and bond markets to remain volatile over the near term or at least until there is more clarity regarding future actions of central banks to curb inflation and the potential impact those actions might have on economic growth as they take hold.
Kevin McCreadie is Chief Executive Officer and Chief Investment Officer at AGF Management Ltd. He is a regular contributor to AGF Perspectives. Click to learn more about AGF’s fundamental, quantitative, and alternative investing capabilities.
Notes and Disclaimer
© 2022 by AGF Ltd. This article first appeared in AGF Perspectives. Reprinted with permission.
The commentaries contained herein are provided as a general source of information based on information available as of May 20, 2022, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Market conditions may change investment decisions arising from the use or reliance on the information contained herein. Investors are expected to obtain professional investment advice.
The views expressed in this blog are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds or investment strategies.
AGF Investments is a group of wholly owned subsidiaries of AGF Management Limited, a Canadian reporting issuer. The subsidiaries included in AGF Investments are AGF Investments Inc. (AGFI), AGF Investments America Inc. (AGFA), AGF Investments LLC (AGFUS) and AGF International Advisors Company Limited (AGFIA). AGFA and AGFUS are registered advisors in the U.S. AGFI is registered as a portfolio manager across Canadian securities commissions. AGFIA is regulated by the Central Bank of Ireland and registered with the Australian Securities & Investments Commission. The subsidiaries that form AGF Investments manage a variety of mandates comprised of equity, fixed income and balanced assets.
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