The year of the hawks will put the markets to the test: turbulence arrives for stocks and bonds

This could be the year of the ‘hawks’. There are many investment banks that have played in recent days with the lexicon to try to create ingenious phrases with the monetary tightening that is coming: ‘The great flight of the hawks is coming’, ‘hawks on, risk off‘,’ the release of the hawks’ … are some of the headlines of reports and notes. With inflation at its highest in recent decadesWith the economy growing and creating jobs, this 2022 could be a kind of party for the defenders of the restrictive monetary policy (higher rates and less stimulus). However, the feast of the falcons can put another celebration at risk: the markets.

The Bank of England opened the ban with an interest rate hike in December. Now the rest of the central banks of developed economies are expected to do the same, with the exception of Japan and perhaps the Eurozone, where the ECB continues to deny the proximity of a rate hike, even if the market says otherwise. The truth is that these first ‘pecks’ from the hawks have already caused clear movements in bonds and some tantrum in stocks. Bond yields have risen sharply, while stocks have suffered turmoil that to date has been only a scare.

The interest paid on the bonds has increased. For example, in the case of Europe, since the last ECB meeting (a notable reduction in the purchase of debt was announced) the yield on the Spanish 10-year bond has gone from 0.3% to 0.66%, the interest and the price falls.

In the case of the American bond, since the Fed announced an acceleration of the withdrawal of stimuli (lower purchase of net debt and a real reduction of the balance earlier), the yield has gone from 1.37% to the current 1.78% . This trend has accelerated after the publication of the Fed minutes, which showed a more aggressive tone. Some banks like Goldman Sachs are already talking about four rate hikes in the US in 2022, the first coming in March.

What will happen to the bags?

How can this affect the bags? From BCA Research they comment that the December minutes “have reinforced the aggressive turn of the Fed and generated a chill in Wall Street last Wednesday. As expected, the massive sale of shares was led by sectors sensitive to interest rates. The question investors face going forward is whether stocks are at risk this year as the Fed will normalize its monetary policy. “

“Our asset allocation team shows in a study that while stocks generally correct in response to the Fed’s first rate hike, the decline is ultimately fleeting,” say economists at BCA Research.

In the case of Europe, Citi analysts have published a note on Monday in which they reach similar conclusions: “European stocks may falter with the first rate hike in the US. However, history reveals that they have recovered afterwards. to post gains of 10% in the year following the last three increases by the Fed. The cyclical sectors tend to outperform the defensive ones “, add the experts of the American bank.

Normally, higher interest rates give ‘wings’ to banks, insurers and other firms related to the financial sector, which show great positive sensitivity to interest rates, which in the end are the ‘raw material’ with which they work. After all, the financial sector is the economy’s great ‘creditor’, channeling savings into investment. However, the most indebted firms (the debtors of the economy) may suffer from a rise in the price of money.

Rate hikes will lead to higher nominal yields on bonds. When this happens, safe values ​​can be sought in environments of rising interest rates. Citi experts assure that “European cyclical stocks outperform defensive ones when US bond yields rise. Banks, automobiles, and insurance tend to lead, while healthcare, personal care, utilities, food and beverages lag behind. “

What if this time is different?

There is always the risk that this time it will be different. From BCA Research they believe that a scenario different from that of recent decades cannot be ruled out given the high levels of debt (they will suffer with the rate hikes) and the force with which inflation seems to have woken up. “These benign results are likely to depend on inflation, which is significantly higher today than it was during the last four rate hike cycles. If inflation slows as economic activity normalizes this year and supply chain disruptions slow down. moderate, the Fed will not be forced to adjust its policy aggressively. “

However, “if, as our emerging market strategists expect, high inflation expectations trigger a spiral of prices and wages, then higher inflation could cause the correlation between stocks and bonds to turn negative. Our team looks to the second half of the 1960s, when the relationship between stocks and bonds turned negative amid high inflation, as a framework for what to expect in the future. This scenario would hurt equities. “

Nonetheless, the overall view from BCA Research (beyond its emerging market strategists) remains that inflation will moderate this year. Although the normalization of monetary policies could lead to more volatility and turbulence, so “we anticipate single-digit returns of US equities this year. In the meantime, we will be monitoring long-term inflation expectations to control if they are unanchored. and, then, threaten to unleash a spiral of prices and wages “, these experts sentence.

On the other hand, and going beyond the US and Europe, we must take into account the differences between some regions and others. Emerging markets have traditionally reacted very badly to monetary tightening in the US, as the IMF warns in a recently published note.

Higher interest rates in the world’s leading power will usually be a threat to emerging assets, since capital tends to abandon these economies to seek the profitability offered by certain assets (fixed income) in the US. The return / risk equation totally changes when the Fed raises interest rates. In emerging markets, currencies, debt and stocks can suffer.