Hawkish Fed Dents Tech Stocks, Not Bonds

December 17, 2021

Last week’s Federal Open Market Committee (FOMC) meeting was easily the most important gathering of Fed officials this year. The meeting took on greater importance after Fed Chair Jerome Powell made a hawkish pivot in his testimony to Congress in late November.

At the time, Powell said that it could be appropriate to accelerate the tapering of the Fed’s bond buying program and that inflation was proving to be more of a problem than he and the central bank had initially thought it would be.

A few weeks later, the release of inflation figures that showed consumer prices rising at their fastest pace in nearly four decades—4.9% year-over-year in the core CPI—only added to worries that the Fed was about to tighten monetary policy much more aggressively than investors had imagined just several weeks ago.

When the Fed’s highly anticipated meeting finally came around last Wednesday, the central bank largely delivered what investors had expected. The pace of the Fed’s taper was doubled to $30 billion per month, putting its bond buying program on track to end by March.

Perhaps more importantly, the “dot plot” of interest rate projections from Fed officials showed that the central bank could hike rates by three times in 2022, a much steeper trajectory than investors were envisioning before Powell’s pivot.

In his comments following the Fed decision, Powell emphasized the economy was growing robustly and that it was his expectation inflation was still likely to come down starting next year.

Nevertheless, he and the committee felt it was appropriate to tighten policy so that key prices in the economy—such as those for housing—don’t become unmoored, fueling more persistent inflation that would be tough to stamp out in the future.

High-Valuation Stocks Pummeled

It’s with that context that markets reacted to the Fed’s big decision last week. The initial burst of action was encouraging. The S&P 500 rocketed higher, back near its record high above 4,700. But the momentum stalled in the following days.

Already up 26% year-to-date, the index was facing difficultly advancing further, even with clarity from the Fed and the strong seasonal December period in full swing.

There has also been a strong drag on the index from the relentless selling that has taken place in some of the higher-growth, higher-valuation pockets of the market.

The ARKK Innovation ETF (ARKK) plunged to a 13-month low in the days following the Fed decision, as investors reasoned that rising interest rates would translate into lower valuations for the once-high-flying tech stocks that make up the fund.

 

ARKK

 

Even after a strong snapback rally on Friday, ARKK has lost about a quarter of its value this year. The Global X Cloud Computing ETF (CLOU)—a fund that was such a big winner in 2020 thanks to secular trends and the post-pandemic boom in cloud computing—is down a more modest 3% year-to-date, but that’s still significant underperformance versus the S&P 500.

Some might argue that a reckoning in these former high flyers was inevitable after last year’s eye-popping gains. The threat of higher interest rates may have just been an excuse to bring valuations in these names to more historical levels.

Indeed, by any measure, interest rates are still extremely low. Outside of the most dramatic period of the pandemic in 2020, rates have never been lower in modern history—and there’s a case to be made that there is little the Fed can or will do to change that.

 

US 10-Year Treasury Bond Yield

 

Overly Ambitious Fed?

The 10-year Treasury bond currently yields 1.38%. If—as the Fed currently expects—it hikes rates three times next year and then another three times in the following year, its benchmark federal funds rate will be 1.5-1.75%, inverting the yield curve.

As most yield curve inversions have historically led to recessions, the central bank will be loath to make such a move.

Of course, the 10-year yield could itself increase from here, giving the Fed more room to hike rates without inverting the yield curve—but it might not.

Ultimately, the Fed alone doesn’t set rates; it is beholden to the market as well. And while some investors believe the 10-year bond yield is being held down by worries about the Omicron variant of COVID, there is also the idea that we are simply back to the secular, low-rate environment that’s persisted for most of the past decade.

Outside of a few brief periods, rates have consistently trended lower in the aftermath of a financial crisis. If that’s the case, how high the Fed can hike its target rate will be limited.   

Follow Sumit Roy on Twitter @sumitroy2

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