It was the first quarter of losses since March 2020. The total loss of the S&P 500 for the quarter was approximately 5%. Even more important, however, are the activities on the bond markets, which could help determine the future of the stock markets. The Fed's newfound focus on fighting inflation with the ability to raise interest rates on 15. May's 50 basis point hike has caused the two-year Treasury yield to rise by the most since 1984. This led to a reversal of the most widely watched spread between 2-year and 10-year government bond yields. Why is this so important? Each of the last six recessions, dating back to 1955, has been preceded by a yield reversal. It was followed by a recession of between 6 and 24 months. That's not a lot of information to make investment decisions on. Incidentally, a yield inversion has happened many times in the interim, but without triggering a recession.
The last major inflation figures were around 8%. The next major release comes on 12. April, and it is expected to be in double digits. A consensus estimate for inflation in March is 8.2. But I don't think many are taking into account the 30% rise in oil prices in the process. So the drumbeat about rising inflation will be very much in evidence in the markets. But keep in mind that these numbers are backward looking.
Will the Fed fight inflation?
My guess is that it won't. The last time the Fed faced something like this was in the late 70's. At that time, Fed Chairman Paul Volcker took it upon himself to fight inflation. And it had a lot more wiggle room then than it would have now. It raised interest rates to 20%, above the rate of inflation in 1981. This plunged the US into a recession. But it has had a grip on inflation. But that's not going to happen now. The Fed is more likely to pay lip service to raising rates and not follow in lockstep with the rise in inflation.
There are many reasons for this. The first is the gigantic budget deficit they have created. The second is the fastest rise in mortgage rates we have ever seen. The Fed's threat to raise rates for the rest of the year is already having an impact on the mortgage markets. If it makes good on its announcement, it will destroy the housing market. It certainly wouldn't be good for Main Street. Average 30-year fixed rates recently rose to 4.42% from about 2.75% in December 2020. This is a massive increase in 15 months, and the last three months have been the most dramatic.
Lenders are addressing the Fed, "If you raise rates any more, we'll go way above 5%, and you don't want to deal with that". Housing prices are already at record highs due to past interest rate cut policies. Now monthly mortgage payments are going up, and that means you have less liquidity available. Those with adjustable rate mortgages are feeling the pinch now.
What could the Fed do differently?
The Fed only manages the short end of the yield curve, but there is another major central bank that is very active in the bond markets. This week, the Bank of Japan intervened twice in the same day. It has been buying JGBs in "unlimited amounts" to limit the rise in yields. Yield curve management policy is a game the BOJ has long used to stimulate economic activity. The 10-year yield in Japan is at a six-year high, and they don't like it.
This rise in ten-year yields is not to the liking of other central banks either. The 10-year yield in Germany rose from -10 basis points to +74 points this month alone. So don't be surprised if the Fed also moves to some kind of "yield curve control".