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The strange divergence between stock and bond markets

Inflation in the rich world is currently at its highest in several decades. Interest rates are rising. Nevertheless, the stock markets are still as dynamic as ever. The question is, why are stock markets ignoring inflation and higher interest rates? How to explain this dichotomy?

The interest rate on 30-year mortgages in the United States recently exceeded 5%, its highest level in a long time. The main reason for the rise was the rise in US Treasury bond yields.

The yield on a bond at any given time is the annual return an investor can expect if they buy the security and hold it until maturity. A Treasury bill is a financial security sold by the US government to finance its budget deficit.

The yield on a 10-year US Treasury note on April 12 stood at 2.83%, its highest level in more than three years. This explains why the interest rate on 30-year mortgages has crossed 5%. As Rupert Russell writes in Price Wars: How Chaotic Markets Are Creating a Chaotic World: “As the Federal Reserve set short-term interest rates, long-term interest rates paid on mortgages, loans autos and business loans were determined by bond traders. .”

By buying and selling bonds at a certain price, bond traders determine the actual yield or yield of a treasury bill at any given time. Since lending money to the government of a financially stable country is considered the safest form of lending, the return that could be obtained by investing in a treasury bill becomes a benchmark for all other loans. So, as US Treasury yields have risen, the interest rate charged on home loans has also risen.

But why have Treasury yields increased? Inflation in the United States, at almost 8% when last recorded, has reached its highest level in four decades. In order to control this inflation, the US Federal Reserve decided to raise its main short-term interest rate, the federal funds rate. More importantly, he decided to start withdrawing the money he had printed and pumped into the financial system as a result of the covid pandemic. The idea was to print and pump money into the financial system to drive down interest rates in the hope that people and businesses would borrow and spend more.

Minutes from the last meeting of the Federal Reserve’s monetary policy committee reveal that the US central bank plans to begin withdrawing up to $95 billion a month from the financial system to begin with. If this lasts a year, over $1 trillion could be withdrawn from the US (and therefore global) financial system.

In the aftermath of the covid pandemic, the Fed printed money and injected it into the financial system by buying bonds. This expanded the assets on its balance sheet. As of January 1, 2020, total assets on the Fed’s balance sheet stood at $4.17 trillion. Between then and now, his total assets have more than doubled; as of April 6, the figure was $8.94 trillion.

The Fed now intends to sell these bonds at a rate of up to $95 billion per month and thereby remove the printed money from the financial system. This means that the amount of money circulating in the financial system will decrease. The US bond market is already discounting this possibility and so Treasury bond yields have risen.

This is totally uncharted territory for the Federal Reserve as well as other central banks in the wealthy world. How much will interest rates rise as the Fed begins to shrink its balance sheet? Are central banks ready to let interest rates rise and perhaps even engineer a recession to control inflation?

The bond market clearly thinks so. But the stock market seems to be in a world of its own. Take the case of the Dow Jones Industrial Average, the first American stock market index. It’s only down 5.7% since the end of 2021. This despite the Fed making it clear that the era of easy money is coming to an end, given that price inflation retail in the United States is at 40- year high. The London-based FTSE-100 has risen around 2.4% since the end of 2021, with UK inflation at its highest level in three decades.

So how do we read all of this? Typically, inflation and higher interest rates end up spooking stock markets. But that doesn’t seem to have happened this time around and markets have largely held onto the strong gains they’ve seen over the past two years.

Do these stock exchanges think central banks are bluffing? Do they think that at the first sign of trouble, central bankers will go back to implementing the only monetary policy they seem to know? Flooding the financial system with money, that is.

If the history of the last few decades is any indication, that is exactly what central bankers have done at every sign of significant economic trouble. Stock markets are likely discounting the expectation that central banks will soon revert to easy money policy at the first sign of recessionary conditions.

Of course, given the complexity of the issue at hand, it’s hard to say anything definitive.

Therefore, when it comes to stock markets, perhaps it is time to return to that old Gujarati saying that still rules Dalal Street: Bhav Bhagwan chhe (Price is God).

Vivek Kaul is the author of “Bad Money”.

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