Investment Insight |
The return of inflation – interest rates strike back
Since December 2020, we have had a positive market view. The successful results of trials of the Covid-19 vaccine in November meant the way to generate returns has been to invest on a roaring rebound in the global economy, as government stimulus, low interest rates and pent-up demand for all the things the pandemic denied people – holidays, dining out, shopping – was unleashed.
This ‘reflation’ trade lifted the prices of shares and commodities, such as copper, to record heights. This lifted global shares, especially the share prices of firms hardest hit by the pandemic, such as airlines and retailers. Fast forward to 11 June 2021 | The return of inflation where we discussed that, as inflation increases in the United States, the probability rises that the Federal Reserve (‘the Fed’) will respond by increasing interest rates.
'Inflation is sticky after all' – Jerome Powell
But sentiment changed at the 16 June 2021 Fed meeting where Chair Jerome Powell suggested that it might have to raise interest rates earlier and higher than expected. This was in response to an acknowledgement by the Fed that inflation was tracking higher than expected and showing signs it may be more persistent than expected. Initially, this was a great outcome for NZ Funds client portfolios as interest rates started to increase.
However, the following day some investors started wondering whether the Fed may over-react in its efforts to control inflation and stymie future growth by raising interest rates too soon. Instead of longer-term (10-year and 30-year) interest rates increasing, they fell! This is known as a flattening yield curve as the rise in short-term interest rates leads to a fall in long term interest rates.
The Fed’s ‘overreaction’ catalysed many of the trends that have dominated markets since December to unwind.
Reflecting the Fed’s prospective rate increases, the yield on two-year Treasury bonds jumped to 0.27%, from 0.16%. However, the 30-year yield, which tends to follow long-term growth or inflation expectations, tumbled to 2.02% from 2.21% just prior to the meeting while the 10-year yield fell to as low as 1.36% from 1.55% over the same period.
The Fed is not only influencing interest rates
The prospect of the Fed putting a brake on inflation and growth hit both shares and commodity prices. The S&P 500 slipped from a near-record high to end last week about 2% lower. ‘Value’ shares, which had performed particularly well since December, were hard hit. Copper lost its spark, shedding 8% over the week.
Our enthusiasm of the past six months (expecting interest rates to increase) was underpinned partly by the assumption that the Fed would balance managing inflation while maintaining the same, super-loose monetary policy they have had over the last 10 years. This ‘Goldilocks scenario’ would lead to a growing economy and rising long-term interest rates.
Goldilocks survives
After the 16 June meeting, Fed members have been at pains to point out that the Goldilocks scenario will continue. Interest rates have therefore partly recovered, erasing the falls they experienced, as the Fed communicates its supportive monetary policy.
How interest rates reacted to changes by the Fed has been the key generator of negative performance for clients this quarter. While we are obviously disappointed that the strong returns generated at the beginning of the year have not continued into the second quarter, we are confident that we are well placed to generate strong returns for the remainder of the year.
The global economy continues to accelerate thanks to the positive tailwinds of rising vaccination rates, government spending and pent-up consumer demand. This will be positive for share markets and means that interest rates need to rise (albeit possibly more gradually than previously thought).
The volatility we are currently experiencing in markets should, despite the negative performance impact, be viewed as a positive as it has created an opportunity to reinvest in commodities, shares and other risk assets at cheaper entry points.
This ‘reflation’ trade lifted the prices of shares and commodities, such as copper, to record heights. This lifted global shares, especially the share prices of firms hardest hit by the pandemic, such as airlines and retailers. Fast forward to 11 June 2021 | The return of inflation where we discussed that, as inflation increases in the United States, the probability rises that the Federal Reserve (‘the Fed’) will respond by increasing interest rates.
'Inflation is sticky after all' – Jerome Powell
But sentiment changed at the 16 June 2021 Fed meeting where Chair Jerome Powell suggested that it might have to raise interest rates earlier and higher than expected. This was in response to an acknowledgement by the Fed that inflation was tracking higher than expected and showing signs it may be more persistent than expected. Initially, this was a great outcome for NZ Funds client portfolios as interest rates started to increase.
However, the following day some investors started wondering whether the Fed may over-react in its efforts to control inflation and stymie future growth by raising interest rates too soon. Instead of longer-term (10-year and 30-year) interest rates increasing, they fell! This is known as a flattening yield curve as the rise in short-term interest rates leads to a fall in long term interest rates.
The Fed’s ‘overreaction’ catalysed many of the trends that have dominated markets since December to unwind.
Reflecting the Fed’s prospective rate increases, the yield on two-year Treasury bonds jumped to 0.27%, from 0.16%. However, the 30-year yield, which tends to follow long-term growth or inflation expectations, tumbled to 2.02% from 2.21% just prior to the meeting while the 10-year yield fell to as low as 1.36% from 1.55% over the same period.
The Fed is not only influencing interest rates
The prospect of the Fed putting a brake on inflation and growth hit both shares and commodity prices. The S&P 500 slipped from a near-record high to end last week about 2% lower. ‘Value’ shares, which had performed particularly well since December, were hard hit. Copper lost its spark, shedding 8% over the week.
Our enthusiasm of the past six months (expecting interest rates to increase) was underpinned partly by the assumption that the Fed would balance managing inflation while maintaining the same, super-loose monetary policy they have had over the last 10 years. This ‘Goldilocks scenario’ would lead to a growing economy and rising long-term interest rates.
Goldilocks survives
After the 16 June meeting, Fed members have been at pains to point out that the Goldilocks scenario will continue. Interest rates have therefore partly recovered, erasing the falls they experienced, as the Fed communicates its supportive monetary policy.
How interest rates reacted to changes by the Fed has been the key generator of negative performance for clients this quarter. While we are obviously disappointed that the strong returns generated at the beginning of the year have not continued into the second quarter, we are confident that we are well placed to generate strong returns for the remainder of the year.
The global economy continues to accelerate thanks to the positive tailwinds of rising vaccination rates, government spending and pent-up consumer demand. This will be positive for share markets and means that interest rates need to rise (albeit possibly more gradually than previously thought).
The volatility we are currently experiencing in markets should, despite the negative performance impact, be viewed as a positive as it has created an opportunity to reinvest in commodities, shares and other risk assets at cheaper entry points.
Source: Bloomberg.
Source: Bloomberg.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
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James Grigor is Chief Investment Officer for New Zealand Funds Management Limited (NZ Funds) and a member of the NZ Funds KiwiSaver Scheme. James' comments are of a general nature, and he is not responsible for any loss that any reader may suffer from following it.
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