Markets are falling so far to start the second quarter after a strong start to the year. The main catalyst has been a renewed spike in bond yields which coincided with the release of the latest inflation figures. The most recent rise in bond yields appears to have caught the market off guard. So what’s going on? Let’s dive in.
Inflation picking back up
Inflation, as measured by CPI, peaked at 9% in 2022 and then started a sustained move back down. This doesn’t mean prices for goods and services went lower. Rather, the pace at which they’ve increased has slowed. By the middle of 2023, inflation had slowed from 9% to near 3%. The problem is that recent inflation reports show one of two potential negatives taking place:
- Inflation is basing at a higher than expected level of 3%
- Or worse, inflation is restarting an upward trend
This rate of change in inflation is a negative for stocks because it disrupts a key expectation that we believe is priced in to the market: that the Fed is done raising interest rates. However, for the Fed to be done raising interest rates, inflation needs to be on a path towards 2% (the stated Fed target). If inflation is not on a path to 2% then the Fed may believe the current level of interest rates is not restrictive enough to slow down inflation.
Market expectations are changing
The recent inflation bump has caused a lot of volatility in the bond market, which is a key market for setting interest rates on everything from mortgage rates to business lines of credit. We wrote last month that interest rates weren’t going down, but that they weren’t really rising either. Well, that’s no longer the case. Interest rates are moving higher across the curve. Here’s a snapshot we shared from last month’s article, capturing the interest rate curve as of March 18, 2024:
At the time, the 3-10 year part of the curve was between 4.30-4.60%. Fast forward to today and this part of the curve has moved rapidly higher, to a range of 4.60-4.80%:
Because all of these interest rates are somewhat sensitive to interest rates set by the Fed, the takeaway can be that the market is expecting the Fed to keep interest rates higher than previously expected. Our belief is that the level of interest rates don’t matter so much as the path to getting there. Markets expect volatility from stocks, not interest rates. But, if we look at the MOVE index, the market is again bracing for major volatility in the interest rate market:
The recent reading of 121 is 20% higher than just one month ago. In other words: bond market volatility is up a lot in a very short period of time. Markets don’t like sudden changes.
Real implications
While the inner workings of the interest rate market are rather arcane, they have easy to understand consequences. If interest rates are going higher then that means any business with a floating line of credit is going to see their borrowing costs rise. Consumers who are currently house hunting with an assumption of a 7% mortgage might have to come to grips with different math if mortgages are back at 8%. The same logic applies for anyone carrying credit card debt.
The prospect of higher interest rates can be a negative overhang as consumers wait to see where things settle out. Like the market, consumers like making purchases with known information. Buying a house or a car is not something you do on Amazon from your couch. Most people take months to make such a big decision. So if consumers start to believe higher interest rates are coming, they may shelve those plans all together.
The mortgage rate market is a great example: mortgage rates are higher today than they were one year ago, yet buying activity has actually picked up! That’s because mortgage rates are more stable than they were one year ago (when mortgage rates were in the midst of a perpetual rise).
Markets don’t like unknowns
In summary, the first sell-off of 2024 was sparked by a familiar negative catalyst of the last two years: inflation fears. In turn, this uptick in inflation is raising concerns that interest rates may not be done going up. The market was previously okay with the elevated level of interest rates, but only because it became a known level. As uncertainty arises as to the peak level of interest rates, markets are undoing some of their recent gains.
In effect, a known (interest rate levels) that the market became comfortable with is starting to turn into unknown. Markets do not like unknowns. We suspect things will stabilize once volatility in the bond market subsides, even if that means interest rates stay at a higher level than before.
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