Careless statement Janet Yellen frightened off the markets and stock indices rushed down. Or maybe everything was planned in advance, and it was “reconnaissance in force”? In this article, we will analyze what the US Treasury Secretary said, and what market participants should prepare for in the future.
What did Janet Yelen say?
In her speech at the Future Economy Summit, Yelen touched on the topic of interest rates, although this is not within her purview. The Federal Reserve is in charge of US rates, and the chairman of the reserve system gives comments on this matter. Jerome Powell… But be that as it may, the following came from Yelen’s mouth:
“It may be that interest rates rise slightly to keep our economy from overheating.”
Investor reaction to Yelen’s speech
The reaction was immediate, with the S&P 500 down 1.5%. After a while, the minister tried to calm down a little market participants who rushed to sell shares of companies, and said that she did not give recommendations to the Fed and did not predict higher rates in the near future. Yelen thinks that growth problems are inflation are temporary and no rate increase will be required.
What is going on?
Why are investors afraid of this situation?
It is known that with a slowdown in economic growth, monetary authorities begin to stimulate demand and business with low interest rates. This allows the population to take a loan to buy goods, and businesses can lend money for further development at lower interest rates.
But the main reason for introducing low rates is low bond yields. As a result, investors are no longer interested in investing in reliable Treasury bonds, and they begin to channel them into the real sector of the economy. These can be corporate bonds, commodities, buying stocks on the stock market, and so on. That is, investors are looking for more profitable options for investing money.
The method of regulating the economy with discount rates was effective before the mortgage crisis in 2008.
After the mortgage crisis, lowering the interest rate alone was not enough. Then the financiers decided to use quantitative easing (QE). The last time the Fed used quantitative easing was in 1932 during the Great Depression.
The reason for using this method was that investors in conditions of low rates on government bonds did not want to actively invest in companies, and banks preferred to direct their finances not to lending business, but to invest in raw materials.
As a result, corporations had to issue bonds to raise money, and since the demand for them was low, the interest on bonds began to grow, as a result, the debt burden on issuers increased and the risk of default increased.
To solve this problem, the monetary authorities began to buy distressed assets and bonds of companies, which increased demand for them, and reduced interest rates.
It was like a breath of air for companies. They were now able to refinance old debts, and borrow money for business development at lower rates. And since the interest rate on loans was low, the population continued to take cheap loans, which kept the positive dynamics of demand for goods.
What are the risks in sharing low rates and QE?
1. The main danger of the simultaneous application of these methods lies in the growth of inflation, which may exceed the planned levels.
2. Inflation provokes a fall in the value of the currency, which makes imported goods more expensive, and if a country is very dependent on imports, like the United States, for example, this will put pressure on business and may provoke a new round of inflation. The United States is now actively working on import substitution.
3. Currency devaluation also affects the attractiveness of investments in a given country. The demand for government bonds is falling, and this leads to an increase in interest on them and debt servicing becomes more burdensome for the government. The external debt of the United States has reached a record level and amounts to 28 trillion. USD.
4. Another risk in this situation is the actions of banks, which can slow down lending to the population and small businesses. In this case, the QE efficiency will be zero, which will lead to the formation of bubbles in the stock market, as companies will increase their debt burden, but their income will not grow.
Is inflation really rising?
Market participants are now only concerned with inflation. The rest of the risks close their eyes. Let’s pay attention to the graph of inflation, is it growing?
The data indicates that inflation reached 2.6% in 2021. But is there a chance that it will not rise further? Therefore, now it is necessary to determine whether there is a potential for further inflation growth.
The source of inflation is primarily the demand for goods and services. If the state distributes money to the population, and the population stores it under the pillow, then there will be no inflation. Therefore, it is necessary to pay attention to whether the income of the population is increasing. The main source of consumer income is wages. According to data from the tradingeconomics website, in March the wages of US citizens rose sharply by 4.4%.
Next, it’s worth looking at the unemployment rate. If it has not reached the pre-crisis levels, then the authorities will do everything necessary to increase employment of the population and bring it back to normal. The history of the past 25 years shows that a drop in unemployment below 5% signals an economic recovery and a phasing out of stimulus.
At the moment, unemployment is at 6%, the pre-crisis figure was 4%.
And another important indicator is the level of consumer savings. If they increase the amount of savings, then the growth in demand for goods slows down, and vice versa. The chart shows that American savings have started to rise again.
You can, of course, go deeper into the statistics, but this data is enough to draw a conclusion.
Summarizing the data presented
The wages of the population are growing, which means there is a potential for growth in spending on goods and services.
Unemployment has not yet reached pre-crisis levels, that is, every month the government will strive to increase employment. This will contribute to an increase in the number of the solvent population and have a positive impact on the economy.
The rise in American savings indicates that there is an additional source of cash that could increase demand for goods and services in the future.
Consequently, there are factors for the further growth of inflation, and now it becomes clear why investors are so worried about this.
Why is the further rise in inflation dangerous?
Rising inflation will push the monetary authorities to either start rolling back quantitative easing or raise the interest rate. An increase in the discount rate looks more logical, since it directly affects inflation. Loans are becoming more expensive, demand is gradually decreasing, raw materials are becoming cheaper, which means that goods are also becoming cheaper.
The flip side of the coin is the debt burden on companies that have borrowed large amounts of money. The rate on previously received loans will rise, and this may lead to bankruptcy of the credited companies. The pandemic has forced very large companies, employing tens of thousands of people, to borrow more to stay afloat. As a result, it is dangerous to raise the rate.
Minimizing the QE program
The way out in this situation is to minimize the QE program. In this case, interest rates will remain the same, that is, companies will have the opportunity to access cheap financing through loans from financial institutions, but banks will already have to choose who is a reliable borrower and who is not.
Money will no longer be distributed to everyone. Thus, a sweep of frankly weak and unprofitable companies can occur, which will not have a significant impact on the market.
Yelen “probes the soil”
But this is all theory, in practice everything can develop according to other scenarios, and in order not to make a mistake, it is necessary to look at the reaction of investors.
Most likely, Janet Yelen’s statement was made deliberately in order to look at the behavior of market participants, if the Fed suddenly starts talking about a rate hike. After all, Yelen is not the chairman of the Fed, but she is not an outsider either, since she held this post in the past. Thus, it was expected that investors would pay attention to her speech, which was later confirmed. The result of this speech was a slight fright for speculators.
How hedge funds dropped the S&P 500
Why did I mention the fear of speculators and not fund managers? In March, there was a decline in the S&P 500 stock index by 3.2%. The reason for this decline was the rebalancing of portfolios of investment funds, as a result of which they sold shares and invested the proceeds in bonds.
Funds simply adjusted their portfolios to a 60/40 ratio: 60% of funds are invested in bonds and 40% in stocks. The sale was technical, but it caused a drop in the stock market. If funds had responded to Janet Yelen’s speech by selling stocks, then we would have seen a more significant drop in stock indices.
In the short term, inflation will increase, and investors’ concerns about this are not unfounded. Jerome Powell assures that high inflation will be temporary and no rate hike will be required in this situation.
The printing press is up and running, and the money supply has grown 24% in 2020, the highest in the history of the dollar. This money has an impact on the market, and as long as quantitative easing continues, stocks will rise, and any fall in securities will be bought by investors, as happened after Yelen’s speech.
In this situation, companies with a high debt burden should be avoided. These include air carriers. During the pandemic, their financial liabilities have reached the value of all assets, and in the coming years they will give their profits to pay off debts.
Janet Yelen’s statement should not be forgotten. She made it clear that options to combat inflation are being discussed on the sidelines, and most likely the first step will be to wind down QE. As soon as officials start talking about this, the growth in the stock market will slow down. Therefore, it is necessary to follow the performances and be ready for correction at any time.
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