2021 Market Review

2022 might be a challenging year for equity markets. In the coming year, the key driver of the equity markets will likely be interest rates. Normally, we would think of a factor such as corporate earnings as being the key driver of market performance. However, this coming year the moves made by the US central bank, the Federal Reserve (Fed), will likely have more overall impact on market performance. This is because over the course of the last decade we have seen interest rates become highly distorted as the responsibilities of both fighting inflation and supporting economic growth have been left to the Fed. And now the Fed needs to unwind the distortions in the bond markets.

Historically, interest rates have served as a guide for equity market performance. As an example, in 2007 (a fairly “normal” year) with the Fed behaving as it usually has, 30-year nominal Treasury rates held steady between 4.5% and 5.5%. A nominal interest rate is composed of two pieces, expected inflation over the term of the rate and a real interest rate, which should equal real economic growth over the term of the rate. So, in 2007 with the Fed strictly targeting a 2% inflation rate, the market likely expected a 2% rate of inflation over 30 years. This means the market was expecting real economic growth of about 3% over 30 years, a reasonable value because it corresponded to long-run historical growth in the US. So, interest rates were determined by market expectations of the future, and these future expectations subsequently effected equity prices and corresponding equity returns.

Predominantly, the mechanism the Fed used to target 2% inflation was to control short-term interest rates, choosing to leave long-run interest rates in the hands of the market. There is a one-to-one correspondence between an interest rate and bond price. So, the Fed essentially controlled short-term interest rates by buying or selling short-term bonds to force these bonds’ prices to be at a point where their corresponding interest rates matched what the Fed was targeting.

In early 2009, going beyond its customary mechanism, the Fed did something it had never done before. It sought to control long-term interest rates as well as short-term. This new policy was called “quantitative easing,” and the Fed targeted long-term interest rates using the same tool it used to control short-term interest rates — by buying or selling long-term bonds. Therefore, as it sought to hold down long-term interest rates, the Fed started buying long-term bonds.    

The side effect of the Fed trading long-term bonds is that the Fed implicitly also affected equity market moves. The reason for this is that equity markets typically move in the opposite direction of bond markets. The simplified way to understand this is that when investors sell bonds (causing bond values to decrease), they must do something with the cash that comes from those sales. That cash typically goes into equities. As a result, when bond markets go down, equity markets typically go up. Vice versa, when equity markets drop, investors who sold those equities tend to invest the resulting cash in bonds, causing bonds to go up. Thus, when equity markets drop, bond markets go up.

Therefore, as the Fed tried to drive up bond prices (and drive down interest rates) by buying bonds, investors were selling bonds to the Fed and putting the resulting cash from the sales into equities. This naturally caused equity prices to go up, producing healthy equity market returns (as we’ve experienced for most of the last decade).

However, through these moves the Fed has caused substantial market distortions. For example, consider the current 1-year nominal Treasury rate of about 0.5%. As we did above, we can break this interest rate into its two components: expected inflation and real economic growth. Annual inflation is currently running at about 7%. So, if we think this rate of inflation will continue for another year, then real economic growth over the next year is projected to be -6.5% (0.5% - 7.0%). This would mean the markets are projecting a disastrous stagflation (inflation + recession) scenario for the economy in the coming year.

Now instead of short-term interest rates let’s consider long-term interest rates. The current 30-year nominal Treasury rate is about 2.0%. Historically, real economic growth in the post-World War 2 era in the US has been about 3.2%. So, if the markets assume about 3% historical real growth in the US over the next 30 years, then that would imply the markets are expecting -1.2% (2.0% - 3.2%) deflation per year for the next 30 years. This would mean the markets expect the US economy to more than double in size while prices (including home prices, stock prices, etc.) to decrease by over 30% over the same period. This scenario seems even more implausible than the previous one.

In fact, since the first set of market expectations above is derived from short-term interest rates, and the second set is derived from long-term interest rates, it means the markets are simultaneously expecting both scenarios to occur.

What both of these examples show is that there are severe distortions currently in the bond markets causing short-term and, especially, long-term interest rates to be at unsustainable levels. These distortions are occurring as the Fed intervenes in the markets for short-term and long-term bonds, keeping interest rates artificially low across all maturities. To accomplish this, the Fed is pumping enormous amounts of liquidity into the markets, thereby causing its balance sheet to swell at unimaginable rates. Thirteen years ago, the Fed’s balance sheet was less than $900 billion, and now it is over $9 trillion and growing at the rate of $2.5 trillion per year currently.      

Market distortions are unsustainable, and the question is not if they will end it is only when and how fast they will end. In general, the faster distortions unwind themselves, the greater the financial market volatility we experience. The Fed knows this, and that is one reason they have decided to not only stop quantitative easing but also raise short-term interest rates. Essentially, they have decided to raise interest rates across all horizons, and notably to let the market determine long-term interest rates again. With the current high inflation rate and high real economic growth rate, that could mean long-term interest rates in the 5% to 6% range — a perfectly normal level from a historical perspective. However, this would mean tremendous losses on bonds. A 30-year Treasury bond trading at $1000 at current interest rates (2%) would drop by over 40% in value as the 30-year interest rate went up to 6%.

The effects on equity markets would be less drastic but would nevertheless be negative. As the Fed slowed its purchases of bonds (and possibly sells off some of its existing holdings), investors would have to sell equities to purchase the extra bonds that would float in the economy, i.e., that the Fed would have otherwise purchased. This selling of equities would cause a drag on equity markets. So, both equity markets and bond markets would drop in tandem, breaking the normal pattern that we have seen historically of the two always moving in opposite directions. In fact, some have speculated that recent market performance is reflecting the start of this process as long-term interest rates have gone up (and therefore bond markets have dropped), while equity markets have also dropped.

However, we are in unknown territory, as there is no historical precedent for the interventions the Fed has executed over the last decade and what it is about to do in unwinding these interventions by shrinking its balance sheet. So, how the Fed goes about this process will be closely watched this coming year and will greatly affect not only US equity market performance but also the global equity markets.