The stock and bond market routs in 1H2022 were caused by the Federal Reserve jawboning their intention to tighten monetary policy by raising the short-term fed funds rate and raise longer-term rates by ending their immense purchases of Treasuries and mortgage bonds (and finally allowing them to roll off when matured).
So far, the fed funds REAL (inflation-adjusted) rate is still deeply negative. The Fed has only raised the fed funds rate to 1.21% while CPI inflation is 8.6%.
So the market’s reaction is anticipation that the Fed will actually do what it has announced: raise the fed funds rate to “neutral,” a zero-to-positive real rate that will neither stimulate nor slow the economy.
Investors who are licking their wounds should realize that the losses to date do NOT include the potential losses in the real economy (profits from companies) caused by higher rates.
Recession expectations pushed down Treasury yields last week. (It’s normal for yields to fall during a recession. That causes bond prices to rise.) The growing fear of recession that pushes up bond prices also pushes down stock prices.
There are plenty of Macro surprises left in 2H2022.
**Markets Had a Terrible First Half of 2022. It Can Get Worse.**
**The first six months were full of surprises, from surging inflation to a crypto implosion. Get ready for more shocks in the second half.**
**By James Mackintosh, The Wall Street Journal, July 2, 2022**
**While investors are at last focused on recession uncertainty, risks elsewhere in the world could hit U.S. investors, too. Japan might finally be forced to relent and allow bond yields to rise, which would suck back cash the country’s investors had poured overseas. In Europe, the central bank has promised a new plan to support Italy — but we’ve seen this show before. If it follows the pattern of too little, too late, we could see a return of the eurozone debt crisis, something markets are not prepared for.** [Recall 2010-2011, when the U.S. economy was slowly recovering but the stock market was hit by the Euro debt crisis. – W]
**Investors woke up to the indirect effect of the Fed, which is to weaken the economy. This has almost the opposite effect on asset prices. A weaker economy means less inflation than otherwise, justifying lower bond yields. It also hits earnings, particularly for cyclical companies, which tends to hurt stocks with relatively low valuations more than growth stocks....** [end quote]
For stock traders, these are potential cyclical changes overlaid on the trend change of rising interest rates.
Rising interest rates hurt growth stocks worst, especially unprofitable, highly indebted tech stocks.
But a recession would hurt the profits of cyclical and materials companies. Their stock prices, which have done well until now, would suffer in a recession.
High-rated bond prices would rise in a recession. But low-rated investment-grade and junk bonds would be undesirable since highly-indebted companies might default in a recession.
Nobody knows yet (not even Jerome Powell) whether the Fed’s actions will cause a recession. Nobody knows whether inflation will decline or whether the economy will end up in stagflation, like the 1970s.
But there are plenty of extraneous surprises that could roil the Macro weather.