Why markets are gripped by fear of higher interest rates

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The month of September has been a cruel one for stock investors, as global markets have tumbled amid rising fears of higher interest rates. The latest trigger was a series of monetary policy announcements from major central banks, which signaled that they are prepared to keep rates high for longer to combat inflation and support economic recovery.

Central banks deliver a hawkish message

The market downturn began with the US Federal Reserve’s meeting on September 20th, which revealed that most of its policymakers expect to raise rates at least once more this year and three times in 2024. The Fed also announced that it will start tapering its bond-buying program, which has been pumping liquidity into the financial system, by the end of this year.

The Fed was followed by other central banks, such as the Bank of England, the European Central Bank, and the Bank of Canada, which also hinted at tighter monetary policy in the near future. The Bank of Japan was the only exception, as it maintained its negative interest rate and massive asset purchases.

The hawkish tone of the central banks surprised many investors, who had hoped for a more gradual and cautious approach to withdrawing stimulus. The market had also underestimated the impact of the Delta variant of the coronavirus, which has slowed down the global economic recovery and increased uncertainty.

Why markets are gripped by fear

Bond yields surge and stocks slump

The reaction of the bond market was swift and severe. The yield on the 10-year US Treasury bond, which moves inversely to its price, jumped to a 16-year high of 4.5%, reflecting the expectations of higher inflation and interest rates. The yield on the 10-year German bund, the benchmark for the euro zone, rose to 2.8%, the highest level since 2011. The yield on the 10-year British gilt also climbed to near the peak it reached last autumn, when the market was in turmoil.

The rise in bond yields put pressure on stock prices, as higher borrowing costs reduce the present value of future earnings and dividends. The S&P 500 index, the broadest measure of the US stock market, fell by 7% in September, its worst monthly performance since March 2020. The MSCI World index, which tracks stocks from 23 developed countries, dropped by 6%, its biggest decline since October 2018.

The sectors that suffered the most were those that are sensitive to interest rates, such as utilities, real estate, and technology. These sectors had benefited from the low-rate environment, as they offer stable cash flows and growth prospects. However, they also tend to have high valuations, which make them vulnerable to a correction when rates rise.

What lies ahead for the markets?

The outlook for the markets depends largely on how the central banks will manage the transition from an ultra-loose to a more normal monetary policy. The challenge is to balance the need to contain inflation and prevent financial imbalances, while avoiding a sharp slowdown in economic growth and a disruption in financial stability.

The central banks have tried to reassure the markets that they will act gradually and flexibly, and that they will communicate their plans clearly and transparently. They have also emphasized that they will not overreact to temporary spikes in inflation, which they expect to subside as the pandemic-related supply shocks fade.

However, the markets remain skeptical and nervous, as they face several risks and uncertainties. These include the evolution of the pandemic and the effectiveness of the vaccines, the fiscal policy stance and the debt sustainability of the governments, the geopolitical tensions and the trade disputes, and the potential bubbles and imbalances in some segments of the financial system.

The markets will also have to adjust to a new reality, where interest rates are higher and more volatile than they have been for a long time. This will require a revaluation of the risk and return of different assets, and a reallocation of the portfolios of investors. The process will not be smooth or painless, and it will likely entail more volatility and corrections in the months ahead.

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