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Last week’s U.S. Federal Reserve policy meeting suggested the world’s most important central bank was inching closer to tightening monetary conditions. This note considers the potential impact on bond yields and equity markets.
The Fed turns a little hawkish
The upshot of last week’s Fed policy meeting was that it signalled a likely tapering of bond purchases following the November policy meeting (which has long been my preferred timetable). In doing so, the Fed is trying to give sufficient warning to the market to smooth the adjustment in expectations – and hopefully avoid a repeat of the 2013 taper tantrum in which bond yields surged following the last announcement of reduced bond purchases.
The Fed also indicated that a complete wind-down in purchases could be wrapped by mid-2022 – or just over six months away – which is a bit faster than I expected. That implies a step down in bond buying of US$15 billion per month.
Apart from tapering news, the other aspect raised in the Fed meeting was the ‘dot plot’- or Fed member expectations for where the Fed funds rate might be over the next few years.
As seen in the chart below, and as feared by the market, two more Fed members brought forward their anticipated first rate hike from 2023 to 2022. Nine of eighteen members (i.e. 50%) now expect the first rate hike to take place next year. The median expectation is for three 0.25% rate hikes by the end of 2023.
Of course, this outlook is dependent on the economic outlook, but assuming the U.S. economy shakes off the Delta variant in the next few months, a late 2022 rate hike now seems quite possible. What will be critical is the speed with which the U.S. labour market tightens over the coming year and whether this is associated with a notable lift in broad measures of wages growth.
U.S. 10-year bond yields could move to 2% by end-2022
To my mind, it will be the expectation of Fed rate increases – not tapering per se – that will have the greatest potential impact on bond yields over the coming year.
International research does suggest that bond buying since the GFC has had a notable impact on long-term bond yields. Indeed, QE rounds are estimated to have lowered long-term yields by around 50-75 bps for every 10% of GDP increase in a central bank’s balance sheet1. The Fed’s COVID response has been to increase the balance sheet by around 15% of GDP (from 20 to 35% of GDP). If we take the average effect above (62.5bps) and halve it to allow for the fact this is a late stage QE program, a broad estimate would be that a 15% of GDP increase in the Fed’s balance sheet since COVID has helped hold down U.S. 10-year bond yields by around 0.5%.
Note, however, this research suggests it is the size of bond holdings, not the rate of purchases, that most affect yields – the Fed so far has only hinted at a gradual wind-down of bond buying (i.e. the balance sheet will still grow for a time before levelling out). Even were the Fed to stop buying bonds in mid-2022, it may still be a further year or so before it might actually contemplate selling some bonds back to the market.
That said, based on my U.S. 10-year bond model forecasts, yields could reach 2% once two 0.25% rate hikes are priced into the market within a twelve month period – which may well be some time later next year.
Higher interest rates could be a headwind for equities
The challenges for equities are evident in the chart set of S&P 500 fundamentals below: if 10-year bond yields rise to 2% while the bond-to-equity yield gap holds at its present level of 3.3%, it would imply a market earnings yield of 5.3% or a PE ratio of 18.9 – or about 10% below the current level of 21.
If the equity-to-bond yield gap moves back to its average of 3.75% since mid-2013 (a time period over which the underlying trend in bond yields and the equity-to-bond yield have been reasonably flat), the earnings yield would rise to 5.75%, implying a PE ratio of 17.4 – or 18% below current levels. Note in the latter case, the PE ratio would have also fallen back to its average level since mid-2013.
Of course, potentially offsetting any downward pressure on equity prices from a falling PE ratio would be rising earnings – which, based on current market expectations, are forecast to rise by a further 12% by end-2022. And it’s also possible that the equity-to-bond yield gaps narrows further if interest rates rise (its 50-year average is closer to 2.5%!) limiting downward pressure on PE valuations.
Either way, Fed tightening, when it comes, would most likely lead to at least a market correction
As seen in the chart below, while we usually need a U.S. recession to cause a decline in U.S. equity prices of more than 20% (the one exception in recent decades being the 1987 collapse), market corrections of between 10 and 20% can take place during economic expansions – and a leading catalyst for these corrections is Fed tightening cycles.
Indeed, as can be seen below, 5 of 7 non-recessionary market corrections of 10-20% have been associated with Fed tightening – the most recent being 2018.
That said, this is not always the case and will depend on the strength in corporate earnings at the time. The early-stage Fed tightening cycles in the mid-90s and mid-noughties were not associated with market corrections.
Which sectors have the potential to benefit most from rising bond yields?
Although equities overall may come under downward pressure when bond yields rise, as seen in the chart below, one sector that has tended to do better than most in these periods is global banks. Because many banks have a pool of deposits paying low to zero interest rates, rising bond yields have tended to lift lending rates by a relatively greater amount – widening their net-interest margins, which in turn supports profitability and relative share price performance. Exposure to global banks is possible through the BetaShares Global Banks ETF – Currency Hedged (ASX Code: BNKS).
Source: Bloomberg. Past performance is not indicative of future performance of any index or ETF. Index performance does not take into account fees and costs. You cannot invest directly in an index.
There are risks associated with an investment in BNKS, including market risk, international investment risk, bank sector risk and concentration risk. For more information on risks and other features of BNKS, please see the PDS, available at www.betashares.com.au. An investment in a BetaShares Fund should only be considered as a component of a broader portfolio.
1. RBA Bulletin – June 2021 Finance
An Initial Assessment of the Reserve Bank’s Bond Purchase Program