Around this time last year, we discussed that there was a disconnect between the rate at which the Federal Reserve expected interest rates to rise and the rate of increase implied by equity and bond prices. The result was for a reasonably sharp but reasonably limited decrease in asset prices around the early part of this year. The same set of conditions have prevailed in the last few weeks.
It is widely reported in the press that investors are reacting to a rise in the 10 year rate and to the threat of a trade war and just about anything else.
In our view, market movements are almost entirely due to price changes connected with the potential for changes in short term interest rates.
Consider the possibility of a 1% rise in the main policy rate of interest in the US, the US equivalent of our Bank Rate (or ‘base rate’) is the ‘Fed Funds rate’. Today, the upper limit on rates in the US is 2.25%. A month ago, bond prices implied that the probability of a Fed Funds rate at 3.25% by this time next year was just 11.5%. At that time the Federal Reserve thought there was a chance as high as 50%. That’s a big disconnect.
And recent comments made by Jerome Powell, Chairman of the Federal Open Market Committee, have highlighted that disconnect. Jerome Powell thinks the US economy is doing very well and can happily sustain a gradual increase in interest rates. We think he is probably right.
In the first week of October, the yield on the 10-year treasury spiked higher from 3.0% to 3.25%, exactly as we would expect if the market was beginning to reappraise its assessment of future interest rates. Indeed, the market implied probability of a 1.0% rate rise by this time next year went from 11.5% to 20.1%.
And where the bond market went in the first week of October, the equity market went in the second week. It is no surprise that those stocks most sensitive to interest rates (low yielding, highly valued tech stocks for example) are those that have fared worst.
In our view, a rate rise in the order of 1.0% a year represents some kind of ‘not-too-fast, not-too-slow’ rate. And we think there is indeed a 50/50 chance that the Fed will increase rates by the full 1% over the next 12 months, beginning with a rate rise in December. We would feel much more comfortable if the market was priced for something like a 30% chance. So, a little more volatility, as prices further adjust, is consistent with this outlook. If we are right in this assessment, the extent and duration of that volatility should be limited.
We should remember that the reason the Fed want to raise rates is that the US economy is doing well enough to sustain rate rise. A strong US economy is good for the world economy. What is good for the world economy is good for investors. In any case, the correct course of action is for long term investors is to stay focused on the long term. We see nothing unusual in the recent market movements.