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Gravity is Gone

• The Federal Reserve (Fed) has used policy tools as “gravitational pull” to keep interest rates low in pursuit of employment and stability mandates.

• The price of longer duration assets are more sensitive to changes in interest rates.

• As rate increases have been ingested by the markets, both long duration bonds and equities with higher valuations (and higher “implied durations”) have been vulnerable and suffered the largest drawdowns YTD.

Since the Great Financial Crisis, the Fed has used the policies of Quantitative Easing and a low Federal Funds Rate to suck interest rates down with the gravitational pull of a giant black hole with hopes of stimulating economic growth by “wealth effect.”

The "wealth effect" is the notion that when households become richer as a result of a rise in asset values, such as corporate stock prices or home values, they spend more and stimulate the broader economy.
- National Bureau of Economic Research

The Fed has a dual mandate of 1.) Price stability and 2.) Maximum sustainable employment. For as long as inflation was running low, the Fed was able to seek maximum employment by applying these policies to set interest rates at historically low levels. Today, with low unemployment and high inflation, the Fed is reversing its course using these same blunt tools, and signaling more aggressing rate hikes and Quantitative Tightening to combat rising inflation.

The giant Fed “Black Hole” is disappearing, gravity is gone, and interest rates are rising – in a sense, creating a “reverse wealth effect” to slow demand. 

The Fed uses the Federal Funds Rate to control rates at the short end of the Treasury Yield Curve, and uses bond buying and selling (aka Quantitative Easing/Tightening) to control interest rates at the long end (longer maturities) of the curve.

Let’s take a look at the impact of their recent announcements to raise the Federal Funds Rate and begin Quantitative Tightening since the beginning of the year:

20220503-chart-1The chart nearby compares the Treasury Curve from 12/31/21 vs. 04/28/2022. The lower bar chart portion shows the difference in rates between the two dates in basis points (1/100 of a percent). As illustrated, the largest moves have been in the short end (shorter maturities) of the curve, as guidance on moving the Federal Funds Rate has a very direct and understood impact on shorter duration Treasury Yields.

However, because of the outsized influence duration has on total returns, the largest price impact in asset values has been to longer duration assets, and we are seeing this across bonds and equities.

Equity Implied Duration

In the chart nearby, we use equity valuations to infer duration because in the simplest terms, equity valuations are akin to an implied duration. For example, a Price-to-Earnings ratio (P/E) of 20x, is a valuation equal to 20 years of the most recent earnings, which would be a longer duration than a company with a P/E of 10x, or a valuation of 10 years’ worth of earnings and the price of longer duration assets have higher sensitivity to changes in interest rates.

20220503-chart-2As illustrated, both shorter duration bonds and shorter “implied duration” equities have been the least vulnerable to rising interest rates, whereas longer duration assets exhibit the largest drawdowns so far. Investors should consider their exposure to rising interest rates in both their fixed income and equity allocations, as well as consider whether the market is currently pricing in all of the future effects of the Fed’s policy moves.

Although interest rates are only one of many components of price movement, there are potential pitfalls to allocating to more vulnerable segments of the market. Keep in mind that price stability is core to the Fed’s mandate and asset stability is secondary.

If inflation remains stubbornly high, the Fed is likely to use its tools to bring it down – and the giant black hole will continue to reverse its gravitational pull which had been keeping interest rates at persistently low levels.

Important Disclosures & Definitions

Bloomberg 1000 Index: a float market-cap-weighted benchmark of the 1000 most highly capitalized US companies. One may not invest directly in an index.

Bloomberg US Long Treasury Index: measures the performance of US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury with a maturity greater than 10 years. One may not invest directly in an index.

Bloomberg US Short Treasury Index: measures the performance of the US Treasury bills, notes, and bonds under 1 year to maturity. One may not invest directly in an index.

Bloomberg US Treasury Intermediate Index: measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury with maturities of 1 to 9.9999 years to maturity. One may not invest directly in an index.

Duration: the sensitivity of an assets price in response to the change in interest rates.

Fed Funds Rate: the target interest rate set by the Federal Open Market Committee (FOMC). This target is the rate at which the fed suggests commercial banks borrow and lend their excess reserves to each other overnight.

Price/Earnings (P/E) Ratio: a valuation ratio of a company’s current share price compared to its per-share earnings.

Quantitative Easing: a monetary policy strategy used by central banks where they purchase securities in an attempt to reduce interest rates, increase the supply of money and drive more lending to consumers and businesses.

Quantitative Tightening: a monetary policy strategy used by central banks where they reduce the pace of reinvestment of proceeds from maturing government bonds in an attempt to raise interest rates, decrease the supply of money, and reduce lending to consumers and businesses.

Treasury Yield Curve: a graphical representation of the yields (y-axis) on debt instruments with different maturities or tenor (x-axis).

ALPS Advisors, Inc. is affiliated with ALPS Portfolio Solutions Distributor, Inc.

ALPS Portfolio Solutions Distributor, Inc., FINRA Member.

APS001973 05/31/2023

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