Here is a recap of market performance for the first half of June and year-to-date:
So far in June, markets have continued to decline. Overall, bonds have held up best, while all stocks categories have fared poorly. Since the beginning of the year, all four asset classes are down double digits, and all stock asset classes are deep into correction territory.
Higher Interest Rates
If you want to know what’s been behind the fall in asset prices this year, it can be summed up in five words: higher inflation and interest rates. Specifically, the following two categories affect short-term rates:
- Current Federal Reserve interest rate increases
- Market expectations for future increases
At the beginning of the year, the Federal Reserve set their target interest rate as a range between 0% – 0.25%. In other words, 0-25 basis points (bps), since 1 basis point equals 0.01%.
In March, the Fed increased the rate 25bps. In May, they increased 50bps, and yesterday they increased another 75bps in order to try and combat stubbornly high levels of inflation. These hikes bring the target rate to 150-175 bps, but with most recent inflation numbers north of 8%, markets are expecting interest rates will continue to climb.
The graph below shows the percentage probability (vertical axis) of different Fed rates (horizontal axis) as of December 14, 2022, which is roughly six months away:
The chart shows that markets expect the Fed rate to be somewhere between 300 and 450bps by the end of year. If this materializes, it would be a significant change from the environment at the beginning of the year, when short-term interest rates were essentially zero.
These interest rate movements affect financial markets in a few ways.
First, bonds fall in price and experience negative returns. While this is painful for investors, there are some silver linings. Short-term bonds that mature within a few years generally fall much less in price than longer-term bonds. Also, new bonds will be issued at higher rates and provide higher future rates of return. So even in a difficult environment, there are ways to mitigate the current pain, as well as potential for future benefits.
Secondly, stocks have also fallen in price. If bonds carry higher yields, more investors may be willing to hold a higher allocation to bonds since the potential returns are higher. This reduces the demand for stocks, causing them to decline. But again, the current market volatility can provide opportunities for investors. Just like in bonds, not all stocks have fallen the same amounts. And as prices for stocks decline, they create the opportunities for higher future returns for investors willing to hold or buy more at lower prices.
This year has been challenging so far, but there are ways to use it to your advantage. If you would like to talk more about rising interest rates and the impacts on your portfolio, please let me know.