By Saksham Bhatnagar
There two major themes that are ongoing:
Fed Rate Hikes + Lower QE (1 Year):
This would mean the lot of the bonds that are used as collateral today for leveraged trades and market making cannot be used in the same capacity as Fed reduces its Balance Sheet and start selling these bonds. This dynamic is already being priced in by the bond market with yields rising across these bonds. For example some the bonds in QE purchases include Investment Grade bonds (BBB rated and above) as the following chart shows yields have been steadily rising and have accelerated post the FOMC announcement on December 15. What this ultimately means is that it will reduce the ability of market makers and large institutions to provide liquidity to the market, which means the market will be much more volatile over the next year.
Fed Rate Surprise (1–2 Years): If the rates are increased more than expected it could cause a short-term crash in the equity markets. Further it may also cause balance sheet distress in overly leveraged sectors and companies.
Fed Put (1 Year): Given the persistent rise in inflation the Fed is now more focused on inflation targeting than the equity market. This means the so-called Fed put has a lower strike i.e. the Fed is willing to let the markets fall further before they intervene. They will definitely be looking at financial markets because financial stability is also their responsibility since the Financial Crisis even though it is not an official mandate like inflation and unemployment. Further the most recent crisis was not a result of a financial instability. In fact systemic risk is down since January 2020 (pre-pandemic). This can be seen in the systemic risk measure published by the NYU Volatility Lab (see the snapshot of the table)
Both equities and treasuries are moving in the same direction (second chart) since the FOMC announcement. Even though this a short period we can expect a stronger positive correlations across asset classes as evidenced by corporate bond yields above. Further since yields have been pushed so far down there is an increase in duration risk i.e. bonds are much more sensitive to rise in interest rates. This will greatly reduce the diversification benefits of bonds. The one asset class that will probably benefit from this are Financials as they earn higher spreads when interest rates increase.