Interest rates came down to low levels and liquidity became aplenty due to the accommodative monetary policies by world central banks, and the expansionary fiscal policies pursued by the governments. This was a direct response to the economic distress caused by the global pandemic and the resultant fall in employment, output, and demand.
It is a fact of experience that these policies helped a rebound in most of the economies though the sustainability of the same is yet to be established beyond doubt. Now that the rebound is happening and there is a recovery in economic activity more or less to the pre-pandemic levels, it is only natural that a review of the policies may happen in the normal course and the markets would also gradually start adjusting to the changed environment.
The resurgence in growth, the re-emergence of inflation, the fears of an imminent return to liquidity and policy normalisation all contributed to the current spike in bond yields. Generally, they say that the central banks follow the markets when it comes to market rates, that is, the rate movements start happening in the markets ahead of central bank policy announcements. It is such circumstances which have led to the kind of events that we are witnessing in the US as also in some of the other economies.
In addition to all this, the inflationary expectations in some of the major economies have been rising. The potential for higher inflation was shown as quite high in the US, and the Fed had on one occasion brought about a change in the inflation targeting converting it from a 2 percent target to an average of 2 percent, with an implicit connotation that the Fed would be tolerant of a higher than 2 percent price level.
In a general assessment, the US economy still stands the chance of encountering a higher price level. This is further occasioned by the additional fiscal stimulus and the expected spending revival in the coming months. The only speed-breaker is the real unemployment rate which is still at 10 percent, a rate that is close to the level where it was during the great recession. While a little bit of inflation is good for the economy, a gradual rise in rates may help the US dollar currency yield, and thereby support the currency to stay where it is with an improving currency yield.
The US inflation is expected to rise in the coming months, and therefore, the US yields, too. The 10-year US treasury benchmark has moved up to 1.50 percent, and it is likely to rise further. But the interesting question about the future is that are these yields going to go up further? What effect these higher rates have on the equity markets? Are the rising inflationary expectations and the rising yields going to adversely impact the equity markets?
The answer is both yes and no. There are many studies done on this question, covering the last 150 years, and the results are interesting. These studies reveal that the optimal inflation levels are somewhere around the 2-3 percent. Below the 3 percent mark but gradually rising inflation is the time when PEs (price-to-earnings) rise, the valuations rise, and is able to sustain at higher levels. But when inflation moves up beyond the 4 percent level and continues to rise, the valuations start falling gradually.
Similarly, long-term data analysis proves beyond doubt that for inflation levels of 2-3 percent, equities provided positive real returns whereas with inflation higher than 3% the ability of equities to provide positive real returns gets impaired. This impairment is due to just one factor – inflation leads to higher official interest rates or base rate, it affects the cost of funds, and therefore, the profitability of a large number of corporates. When cost of funds rise, profitability of corporates come down, their interest servicing capacity too comes down.
That is precisely why rising interest rates is considered the worst enemy of equity markets. But US inflation has not breached the critical levels on the upside, it is still not time to be overly worried. It further affords more comfort as the US unemployment is still high, and that the Fed has indicated continuation of its commitment to liquidity support to effect a sustainable recovery.