Re: Financial topics
Posted: Fri Mar 25, 2022 5:32 pm
You got me as to why the market went up today with rates up big across the board.
Equities' Reaction To Fed Policy
CME Group
March 25, 2022 5:49am
https://www.benzinga.com/economics/22/0 ... fed-policyThe equity market’s rally and high valuation levels cannot be attributed to its optimistic outlook for corporate earnings or cashflows. S&P 500® Annual Dividend Index Futures reveal that investors expect only 1% annualized growth in dividends per year over the next decade in nominal terms. Adjusted for inflation, investors see the real value of the dividends falling by around 2% per year (Figure 4). Yet, despite this rather gloomy scenario, the S&P 500® is within about 5% of the record high. Viewing the S&P 500 market cap as a percentage of GDP, the index remains close to all time highs (Figure 5).
So given the rise in inflation, the expected slow growth in dividends, and expectations for a sharp tightening of Fed policy, why are investors still willing to pay relatively high prices to own shares? Part of the reason may lie in the extraordinarily flatness of the yield curve beyond the three-year point. While 3M3Y has around 200bps of steepness, reflecting the anticipation of tighter Fed policy, 3Y10Y is almost perfectly flat. 10Y30Y has around 20bps of steepness. Equity markets often show more sensitivity to long-term rates than short-term ones. There are two reasons for this:
Long-term bonds are the primary alternative to equities for most institutional (and many individual) investors, and low long-term yields make for unattractive investments.
Models of corporate valuation often use long-term interest rates to discount future earnings and, the lower long-term bond yields, the greater the net present value of future cash flows.
As such, the flat yield curve beyond the three-year point may be shielding equity investors from a potential deeper sell off, at least for now. But there are risks. First, long-term bond yields have begun to edge higher (Figure 6). Moreover, Fed Chair Powell indicated that the Fed wants to contain inflation without causing a recession. That might sound good for equity investors but consider this: one way to avoid causing a recession could be to make sure that the yield curve does not invert as the Fed raises rates. In order to prevent a yield curve inversion, the Fed might reduce its holdings of longer term bonds, accumulated during the recent $4.8 trillion bout of quantitative easing (QE), in order to push bond yields higher as it raises short-term rates. As such, long-term bond yields might rise as the Fed reverses QE which the Fed has indicated likely to begin in May.
There is very little evidence that QE impacts the rate of GDP growth or inflation. Three rounds of QE in the U.S. between 2009 and 2014 had very little impact on either. Even larger rounds of QE in the eurozone and Japan appeared to have little impact on their economies either. What differentiated the most recent QE was that it was done in combination with an unprecedented peacetime fiscal expansion that took Federal spending from 21% of GDP in the year to February 2020, to 35% of GDP in the year to March 2021.
There is abundant evidence, however, that QE tends to flatten yield curves and boost asset prices ranging from real estate to equities. As such, reversing QE might push long-term bond yields higher to the possible detriment of equities even as higher short-term interest rates potentially slow economic growth and help to contain inflation expectations. Finally, there is the possibility that tighter monetary policy triggers an economic downturn which could cause corporate earnings to fall. As such, the equity market, which has resisted higher inflation and the prospect of Fed tightening well so far, might not be out of the woods yet.