Federal Reserve Chairman Jerome Powell speaks during a House Finance Committee hearing in Washington, DC on Wednesday, December 1, 2021.
Al Drago | Bloomberg | Getty Images
US stocks continued their sell-off on Monday as Treasury bond yields continued to climb, an indication that many traders are becoming more confident that the Federal Reserve will hike rates over the next several months.
Traders say the pressure on U.S. stocks isn’t due to material concerns about the economy or fears of a massive Covid-19 resurgence, but rather to repositioning the portfolio for a world with higher borrowing costs.
As the country’s central bank, the Fed is tasked by Congress with maximizing employment and keeping prices stable. The Fed is adjusting short-term interest rates and other liquidity tools to keep inflation at around 2% and cut unemployment as much as possible.
When the Fed finds that the economy is close to full employment – and especially when inflation is hot – it raises interest rates to make it harder for companies to borrow and limit spending that fuel the price hikes.
The Department of Labor reported in December that the prices consumers pay for goods and services rose more than 6% in November, the largest increase since 1982 compared to the previous year.
Many market watchers, including Randy Frederick of Charles Schwab, say hot inflationary pressures almost guarantee the Fed’s rate hikes in the coming months. Central bank members have already telegraphed that they plan to restrict access to cash sooner than initially expected.
These expectations have pushed the yield on the ten-year benchmark government bond higher in recent weeks, with the interest rate recently rising by around 1.77% from a low of under 1.4% in December. Finally, changes in 10-year returns can directly impact consumers through higher mortgage rates and auto loans.
Frederick, director of trade and derivatives at the Schwab Center for Financial Research, said the market appeared to have been surprised by Chairman Jerome Powell’s move away from labeling inflation “temporary” and towards more restrictive monetary policy.
“These are both efforts to fight rising inflation, which I believe has gone much further and much faster than that [Powell] expected, “he said.” So now you have the potential for interest rates that looked like they weren’t going to rise until June. Now there is an 80% chance that this will happen in March. “
Frederick is not alone in this thinking. The recent minutes of the Fed’s meeting, coupled with hot inflation and near-full employment, prompted Goldman Sachs to tell its clients that it now expects four rate hikes in 2022, more than previously expected.
According to the CME Group’s FedWatch website, markets now expect the Fed to hike rates at the March Federal Open Market Committee meeting with a 76% probability, up from around 15% in mid-October.
The Monday sell-off also comes the day before Powell appears at his congressional nomination hearing. Lael Brainard, whom President Joe Biden has appointed as the next vice chairman of the central bank, will testify Thursday.
Lawmakers worried about rising gasoline and grocery store prices are likely to resent Powell at how he and his colleagues at the Fed plan to bring inflation back towards the Fed’s 2% target.
But higher interest rates – or market expectations for higher interest rates – can lead to financial heartburn as traders sell government bonds and high-priced stocks.
“In the technology sector, which tends to be valued very highly, there are many new companies with debt and leverage,” said Frederick. These companies may have a harder time holding cash “because when this debt expires it will have to be replaced at a higher rate”.
Among the three major US stock indices, recent traders’ sales have been focused on the stocks comprising the tech-heavy Nasdaq Composite. The Nasdaq is 8.5% below its all-time high, compared to a 3.5% decline in the S&P 500 and a 2.7% decline in the Dow industrials. The Russell 2000, an index that tracks smaller publicly traded companies, is more than 12% below its record.
Sectors and stocks considered financially more defensive with better near-term earnings expectations outperformed. Utilities like Xcel Energy and Duke Energy gained, while drug makers Merck and Amgen gained 2% and 1%, respectively.