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Wait a Minute

John Lim

MINUTES FROM the latest Federal Open Market Committee (FOMC) meeting, which were released last Wednesday, roiled financial markets. Stocks fell sharply, with both the Nasdaq Composite and Russell 2000 falling more than 3% that day. On the week, the Nasdaq was down 4.5%, the S&P 500 down 1.9% and the Dow Jones Industrial Average 0.3% lower. What did investors read in the minutes that gave them such pause?

For background, FOMC minutes are released three weeks after the meeting itself. They provide far greater color and nuance on the thought processes of Federal Reserve officials than does the official press release that garners all the media attention. By my count, the December FOMC press release contained 1,024 words, versus 9,457 words for the corresponding minutes.

One word that appeared 28 times in the minutes—but which was completely absent from the press release—was “balance sheet.” The Fed’s balance sheet refers to its bond holdings—Treasurys and mortgage-backed securities—now totaling $8.7 trillion. This massive bond portfolio is the result of the Fed’s long-standing quantitative easing program, which has involved buying massive amounts of bonds.

What interested me most from the latest minutes was the discussion surrounding “policy normalization.” This is Fed speak for returning to some semblance of normal monetary policy by raising the federal funds rate from zero—what the Fed refers to as “lift off”—and reducing the size of its balance sheet. In particular, there seems to be a growing consensus at the Fed that its bond holdings should be reduced sooner and at a faster pace.

Many market watchers took this to mean that the initial rate hike may occur as early as March, three months sooner than had been expected. The growing narrative is that the Fed may have finally gotten serious about the risk posed by inflation.

Aside from being a transcript of FOMC meetings, Fed minutes also serve as forward guidance. These transcripts are, no doubt, carefully crafted reports that hint at future policy moves months in advance. This enables the Fed to both gauge market reaction to its intentions and to prevent market surprises when the Fed ultimately acts.

But such forward guidance also moves markets. Given the Fed’s enormous firepower, private investors can and do front run the Fed. This appears to be happening now as market participants digest the implications of a more aggressive—or, at least, less dovish—monetary policy.

Witness the rise in long-term Treasury yields, which had already begun their ascent in December. The upward pressure on yields accelerated after the release of Fed minutes Wednesday. Knowing that the Fed would soon turn from a buyer to a seller of Treasurys, bond investors sold in droves. The yield on the 10-year has risen from 1.35% in December to 1.8%. More than half of that increase occurred last week. The 30-year Treasury yield has followed a similar upward trajectory.

Despite the recent moves, the level of interest rates still makes little sense to me in an environment of 7% inflation. Unless inflation makes an about turn in 2022, the move in Treasury yields may be just getting started.

What are the broader implications of higher interest rates for the economy and financial markets? Rates on home mortgages will climb alongside Treasury yields. Coupled with the outsized gains in home prices last year, this means that housing will be even less affordable.

Bond investors will also suffer, at least in the short term, since bond prices fall as yields rise. Last week, I noticed that most of my bond funds had reached 52-week lows. One silver lining for bond investors: Coupons can be reinvested at higher yields, which will partially offset capital losses. That said, investors who have counted on the stabilizing power of the 60% stock-40% bond portfolio may be in for a nasty surprise should bond and stock prices fall simultaneously.

A final knock-on effect of higher rates is the divergence in stock performance between growth and value stocks. This was exemplified last week, with the Dow industrials significantly outperforming the Nasdaq. Many of the frothiest growth names—with little to no current earnings or dividends—have thrived in an ultra-low interest rate environment. Aside from being able to borrow money cheaply, their lofty valuations incorporate heady growth prospects far into the future. But as interest rates rise, the present value of future dividends and earnings become less attractive, leading to lower share prices. On the other hand, value stocks are more attractive as rates rise, at least on a relative basis, as many have generous cash flows and dividends today.

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