TREASURY RATES INCREASED, AND THE YIELD CURVE FLATTENED……

The markets are in a very unsettling period of transition as the Federal Reserve walks back an extended period of easy money. According to former Fed Governor Bill Dudley, “persistent price increases have forced the Fed to shift its focus from supporting economic activity to pushing inflation back down to its 2% objective…the new focus on price stability will be relentless.” Former Treasury Secretary Larry Summers added that the Fed will need to see the unemployment rate above 5% for a period of five years to achieve its objective of containing inflation. Unintended consequences from the change in monetary policy ranging from currency volatility to credit market stress may also arise.

However, in a recent Bloomberg opinion piece Allianz Chief Economic Advisor Mohammad El-Erian noted that three silver linings are beginning to appear. First, as central banks reverse course, value is being restored in the markets. Second, bonds will likely resume their traditional role as portfolio diversifiers following their first half losses. Lastly, because interest rate risk and credit / recession risk occurred one after the other, markets remain liquid and continue to function well.

Evidence of value restoration can be seen in the rapid decline of forward price earnings multiples. For instance, data from Yardeni Research shows that forward P/E multiples have fallen from 23x to 16x in the US and from 18x to 11x in the European Monetary Union (EMU). Admittedly, these ratios may turn out to be artificially low if earnings growth does not materialize as forecast, but they do reflect a dramatic, downward re-rating of investor sentiment and, hence, prices.

Another potential silver lining that flows from a more “normal” interest rate environment was highlighted by Abby Joseph Cohen in an interview on Bloomberg Surveillance in which she said “for the last few years the fundamentals have mattered less than things like momentum and investor enthusiasm” which, themselves, were a function of cheap money. Now markets are moving into “a situation where beta will be less important than alpha” in both the US and developed international markets. That is, security selection by competent active managers should matter more in the anticipated environment.

To quote El-Erian again, “the promise now is one of a more sustainable destination” free from “an artificial regime that was maintained for far too long by the Fed and that resulted in frothy valuations, relative price distortions, resource misallocations and a (loss of perspective on) fundamentals. Unfortunately, it comes with an uncomfortably bumpy and unsettling journey.”

TREASURY RATES MOSTLY DECLINED AS YIELD CURVE BULL STEEPENED…

TREASURY RATES CONTINUED TO RISE SHARPLY, BUT THE TREASURY YIELD CURVE BEAR STEEPENED…