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Barely three weeks into the year, the financial markets have begun to lose ground from the maximum levels reached at the end of 2021.

The Dow Jones and S&P 500 are down roughly 4% year-to-date (at the time of this writing), while the Nasdaq is nearing correction territory with a 9% drop.

However, the adjustment in these stock markets is minuscule when compared to the mini-crash that is happening in the US fixed income market, where rates along the entire curve have risen substantially.

It is important to remember that the rates paid by the bonds move in the opposite direction to the prices of said instruments, so a rise in rates reflects a fall in prices. In the last 12 months, the 10-year Treasury bond rate went from 1.09 to 1.84%, and just so far this year the increase was from 1.51 to 1.84 percent.

In the case of the 2-year bond rate, the increase in the last 12 months was from 0.12 to 1.02%, and so far this year from 0.78 to 1.02 percent.

Although these adjustments have been enormous, several specialists expect the adjustment to continue in the coming months. In the case of the 10-year rate, the market consensus forecasts that it will reach 2.2% at the end of the year, while the 2-year rate could close at around 1.2 percent.

These forecasts take as a base scenario that inflation will begin a downward trajectory towards the second half of the year and that the Fed will increase the funding rate, whose term is the shortest and is currently located in a range of 0 to 0.25%, up to four times to leave it in a range of 1.0 to 1.25% at the end of 2022.

For many observers, the main risk to markets is that inflation’s downward trajectory is slower and less pronounced. In this scenario, inflation would drop less than expected and would be at a medium-term level higher than what we have seen over the last 10 years.

In such a scenario, the Fed would be forced to accelerate the normalization of its monetary policy. This acceleration in normalization would have two fronts. The first would be to make a greater number of increases in the funding rate. A few days ago, the CEO of JP Morgan, Jamie Dimon, mentioned that the Fed could be forced to raise the funding rate up to seven times, which would place the funding rate close to 2% at the end of the year.

The second front would be to advance and accelerate the process of reducing the Fed’s balance sheet. It is worth remembering that, since the arrival of the pandemic, the Fed has injected almost 4.6 trillion dollars into the markets through the purchase of government bonds. Treasury and mortgage bonds. The Fed’s balance sheet went from 4.2 trillion dollars at the end of 2019 to 8.8 trillion dollars as of January 10.

To give a little more context, the amount injected during the last two years is almost 10% higher than the amount that was injected to combat the Great Recession between 2009 and 2014. On that occasion, the Fed stopped buying bonds at the end of of 2014 but continued to reinvest the resources from amortizations and interest in the market for almost four years.

It was not until 2018 that the Fed began to reduce its balance sheet, selling instruments and withdrawing liquidity very gradually. On this occasion, the Fed will stop injecting liquidity in March and some specialists believe that it could be forced to start withdrawing liquidity during the third quarter of the year. In other words, we would go from the most ambitious quantitative expansion in history to a scenario of quantitative restriction in just six months.

This abrupt change in the demand for Treasury bonds could have a disorderly and greater-than-expected impact on medium- and long-term interest rates, with very important implications for the markets.

The key questions that are in the minds of specialists are two: how long will this liquidity withdrawal process last? And how significant will be the volume of liquidity withdrawn by this process?

Although other central banks – notably China’s – could continue to inject liquidity, it is essential that we prepare for a less liquid environment in which markets have become addicted to near-infinite liquidity provided by central banks in recent years.

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Joaquin Lopez-Doriga Ostolaza

Socio Director de EP Capital, S.C.

Without Borders

Joaquín López-Dóriga Ostolaza is Managing Partner of EP Capital, SC, a consultancy specialized in mergers and acquisitions founded in 2009.

He is a graduate of the Bachelor of Economics from the Universidad Iberoamericana, where he graduated with honors and the highest average of his generation. He has a Master’s degree in Economics from the London School of Economics, where he was distinguished with the British Council Chevening Scholarship Award.

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