At-a-glance
  • There has been a dramatic change in expectations for Fed policy
  • Equity investors have not reacted negatively to the prospect of higher Fed policy rates
  • A reversal of QE could push long-term bond yields higher to the detriment of equity investors

On March 16, the Federal Reserve (Fed) raised rates for the first time since December 2018. The following Monday, Fed Chair Jerome Powell surprised the fixed income market by announcing that the Fed could accelerate its pace of tightening. Fed Fund futures interpreted this to mean that the Fed might begin to hike rates in increments of 50 basis points (bps) for the first time in over two decades. As of March 22, CME’s FedWatch tool priced the probability of consecutive 50bps rate hikes at the Fed’s May and June meetings at around 64%.

These developments underscore how suddenly expectations for Fed policy have shifted. As recently as early October, Fed Fund futures didn’t price any tightening during the coming 12 months. By mid-March, Fed Fund futures priced 200bps of tightening within the coming 12 months (Figure 1). In five months investors went from pricing no policy changes to pricing a return to the 2018 highs.

Figure 1: Investor expectations for Fed policy have shifted dramatically during the past five months

A sudden rise in inflation expectations triggered the Fed to take a more aggressive stance. Ten-year break-even inflation spreads, which measure the difference between yields on standard U.S. Treasuries and Treasury Inflation-Protected Securities (TIPS), have been climbing for nearly two years and have largely led expectations for Fed policy. At first, as the break-even inflation spread rose from anticipating 0.6% average inflation early in the pandemic back to around 2%, its long-term average. Fed Fund futures showed little reaction. But as employment markets boomed, inflation surged towards 8% and long-term inflation expectations rose towards 3%, investors concluded that the Fed might tighten policy much more rapidly than they had previously anticipated (Figure 2).

Figure 2: Inflation expectations rose well in advance of the move in Fed rate expectations.

Meanwhile, equity investors did not appear to be overly upset by the recent rise in expectations for Fed rates – or at least not yet in any case. Between January 4 and February 24, the day that Russia invaded Ukraine, the S&P 500® fell 14%. Since then, it has rebounded by 9% even as expectations for how far the Fed might increase rates has continued to rise sharply (Figure 3).

Figure 3: The dramatic change in expectations for Fed policy hasn’t hurt the equity market too much

The equity market’s rally and high valuation levels cannot be attributed to its optimistic outlook for corporate earnings or cashflows. S&P 500® Annual Dividend Index Futures reveal that investors expect only 1% annualized growth in dividends per year over the next decade in nominal terms. Adjusted for inflation, investors see the real value of the dividends falling by around 2% per year (Figure 4). Yet, despite this rather gloomy scenario, the S&P 500® is within about 5% of the record high. Viewing the S&P 500 market cap as a percentage of GDP, the index remains close to all time highs (Figure 5). 

Figure 4: Dividend futures reveal a pessimistic scenario priced in for growth in corporate cash flows

Figure 5: As a % of GDP, S&P 500® market cap is off its highs but still historically expensive

So given the rise in inflation, the expected slow growth in dividends, and expectations for a sharp tightening of Fed policy, why are investors still willing to pay relatively high prices to own shares? Part of the reason may lie in the extraordinarily flatness of the yield curve beyond the three-year point. While 3M3Y has around 200bps of steepness, reflecting the anticipation of tighter Fed policy, 3Y10Y is almost perfectly flat. 10Y30Y has around 20bps of steepness. Equity markets often show more sensitivity to long-term rates than short-term ones. There are two reasons for this:

  1. Long-term bonds are the primary alternative to equities for most institutional (and many individual) investors, and low long-term yields make for unattractive investments.
  2. Models of corporate valuation often use long-term interest rates to discount future earnings and, the lower long-term bond yields, the greater the net present value of future cash flows.

As such, the flat yield curve beyond the three-year point may be shielding equity investors from a potential deeper sell off, at least for now. But there are risks. First, long-term bond yields have begun to edge higher (Figure 6). Moreover, Fed Chair Powell indicated that the Fed wants to contain inflation without causing a recession. That might sound good for equity investors but consider this: one way to avoid causing a recession could be to make sure that the yield curve does not invert as the Fed raises rates. In order to prevent a yield curve inversion, the Fed might reduce its holdings of longer term bonds, accumulated during the recent $4.8 trillion bout of quantitative easing (QE), in order to push bond yields higher as it raises short-term rates. As such, long-term bond yields might rise as the Fed reverses QE which the Fed has indicated likely to begin in May. 

Figure 6: Bond yields are creeping higher & the Fed might want to avoid inverting the curve

There is very little evidence that QE impacts the rate of GDP growth or inflation. Three rounds of QE in the U.S. between 2009 and 2014 had very little impact on either. Even larger rounds of QE in the eurozone and Japan appeared to have little impact on their economies either. What differentiated the most recent QE was that its was done in combination with an unprecedented peacetime fiscal expansion that took Federal spending from 21% of GDP in the year to February 2020, to 35% of GDP in the year to March 2021.

There is abundant evidence, however, that QE tends to flatten yield curves and boost asset prices ranging from real estate to equities. As such, reversing QE might push long-term bond yields higher to the possible detriment of equities even as higher short-term interest rates potentially slow economic growth and help to contain inflation expectations. Finally, there is the possibility that tighter monetary policy triggers an economic downturn which could cause corporate earnings to fall. As such, the equity market, which has resisted higher inflation and the prospect of Fed tightening well so far, might not be out of the woods yet.

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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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