Market Overview|Weekly Comment

Swift Reactions

Market overview from Quilter Cheviot

By Alan McIntosh, Chief Investment Strategist

Data from the US continues to point to a strong economic recovery, with the unemployment rate almost back to pre-Covid levels. Coupled with an inflation rate that is rising at the fastest rate in 40 years (expected to top 7% this week) it is not surprising that the Fed (the US central bank) has signalled a more hawkish tone in terms of future monetary tightening. What came as a surprise last week however were the minutes from the December Fed meeting, which indicated that as well as ending treasury purchases in March and starting to increase borrowing costs, there was a discussion about reducing the size of the Fed balance sheet – in effect, allowing existing bond holdings to run-off or to be sold in the market. The reaction was swift. Bond yields rose sharply and growth and technology shares (more sensitive to bond yields than “value” stocks) sold off.

There is precedent for this. The Fed reduced its balance sheet between 2017 and 2019. The difference then was that it took place two years after interest rates started to rise. This time round it looks as if the proposal would be to do it in tandem with rates rising. It may well be that the Fed members were simply testing market reaction to the proposal, but if it does materialise, we should expect bond yields to move higher from current levels. To be fair, it is the more speculative areas of the market that would be most impacted (beneficiaries of cheap and plentiful liquidity) under this scenario. However, history is littered with policy errors from central banks. Markets will be hoping that this is not history about to repeat itself.

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