(NYTIMES) – Investors had no trouble gliding past the death and economic devastation wrought by the Covid-19 pandemic last year to drive the market to record highs.
An increasingly healthy economy is what is making them panic.
The US S&P 500 stock index has wobbled, suffering its worst weekly performance recently.
The bond market, too, is showing anxiety, with yields rising sharply as returns in the market for United States Treasury bonds have fallen roughly 3 per cent this year.
The market conniptions are a direct result of several developments that point to the brightening prospects of economic recovery.
Vaccinations are rising, retail sales and industrial production have been surprisingly solid, and, perhaps most important, the Biden administration has pushed its US$1.9 trillion (S$2.5 trillion) stimulus plan through Congress.
“We haven’t seen this scale of fiscal response before, and the market is struggling with how to process that,” said Ms Julia Coronado, founder and president of MacroPolicy Perspectives, a markets and economics consulting firm.
Because the US has never before pumped so much money into the economy, Ms Coronado said, the market is “questioning what some of the unintended consequences could be”.
One clear consequence is expected to be strong growth.
Wall Street economists now expect output to rise by nearly 5 per cent this year. Such robust growth – it would be the best year for the US economy since 1984 – would seem like a good thing for stocks.
After all, a strong economy makes it easier for companies to boost sales and profits, as employment rises and consumers have more money to spend.
But growth brings with it the possibility of rising inflation, which, in turn, could prompt the US Federal Reserve to raise interest rates – and that is what investors are reacting to, with different consequences for the stock and bond markets.
When the pandemic started in March last year, causing a wide panic that led the S&P 500 to lose more than one-third of its value within weeks, the Fed moved to soothe markets and prevent the bottom from falling out completely. It cut interest rates to nearly zero and signalled that it would hold them there.
It also began pumping billions into the markets every month by essentially creating fresh dollars and using them to buy government bonds. Those so-called easy money policies provided a tailwind to the S&P 500.
“Part of the enthusiasm in the marketplace has been that the Fed is going to keep the cocaine going,” said Ms Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management.
“The better and better things are, the less and less rationale the Fed has for keeping rates at zero.”
The Fed’s moves also affect bond markets, usually through rising and falling yields.
In general, yields on government bonds – which are determined partly by interest rates set by the Fed – broadly reflect investor views on how the economy will do over time.
When growth is weak, government bond yields tend to be low.
When growth is fast, those bond yields tend to be higher.
At the moment, investors are worried that the economic rebound will cause inflation.
Few economists currently see a significant risk of runaway inflation. But investors say that the mere possibility of painful 1970s-style price growth might drive the Fed to raise interest rates in order to tamp down the economy.
That would be bad for bond owners. If the Fed raised rates, rates around the bond market would climb. Then, the price of bonds that investors currently hold would have to fall until they produced yields that were comparable to the new, higher rates in the market.
In expectation of that, investors are demanding a higher return now in the form of a higher yield on their bonds. Recently, the yield on the 10-year Treasury note, the most widely watched measure of the government bond market, has jumped above 1.7 per cent at times.
The market for interest rate futures – where investors speculate on where interest rates might go in the coming years – provides a timeline for when investors think this might happen.
Prices there now show a rising chance the Fed raises rates in the first quarter of 2023, earlier than the central bank has guided.
And since the Fed has suggested that it planned to slow down other elements of its easy money policy before lifting rates, investors expect the central bank to start cutting back on help for the market as soon as next year.
Even though chairman Jerome Powell and other Fed officials have recently talked down the possibility that the central bank will reduce its support for the economy any time soon, the yield on the 10-year Treasury note continues to hover above 1.6 per cent.
That is far higher than where it ended last year, at 0.92 per cent.
Higher rates can be a problem for the stock market’s performance.
One reason is that high interest rates make owning bonds more attractive, coaxing at least some dollars out of the stock market.
Higher rates can also make borrowing more expensive for companies, especially smaller ones that have potential but lack a track record of profitability.
Such high-growth companies – Shopify and Zoom Video among them – have fared incredibly well during the recession because their business models benefited directly from the move to working from home. But they were battered in February, and their stocks each tumbled more than 10 per cent as bond yields soared.
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