Prices are rising and consumers are feeling it. Inflation for the calendar year 2021 reached 7%. To put this in perspective, calendar year inflation has not been this high since 1981. When looking at monthly price levels and comparing them to the prior year, we can see that inflation was accelerating for much of 2021 and continues to in 2022. The most recent reading reached 7.9%! When inflation is this high, it is bad for consumers, corporations, and the economy as a whole. As such, both central bankers and politicians will come under pressure to address the problem in the months to come.
The U.S. Federal Reserve increased interest rates on March 16th for the first time since before the great pause of 2020. Short-term interest rates now stand just above 0.25%. While this is a small increase, it is likely the first of many.
When looking at the Federal Reserve dot plot, we can see where participants believe an appropriate short-term interest rate may be at different points in the future. In December 2021 those dots told us to expect a total increase of 0.75% in the calendar year 2022, bringing short-term interest rates from near zero to just over 0.75%.
In the March 2022 press release, the dots looked quite different. After a few very high inflation readings, the Federal Reserve is now telegraphing interest rates closer to 2.0% by the end of 2022. In addition, they have also signaled that they will begin reducing the size of the balance sheet soon. This will further remove the significant monetary stimulus put into place over the past several years. As such, borrowing costs are now on the rise.
With inflation soaring and the Federal Reserve telegraphing increases in short-term interest rates, it is no surprise the general level of interest rates has been rising. If we look at the U.S. treasury yield curve in early January, we can see the short-term interest rates were close to zero, and rates gradually increased as the time to maturity increased.
Fast forward three months and the treasury yield curve looks very different. In general, interest rates are higher with the two-year Treasury rate increasing from 0.8% to 2.3%, and the ten-year treasury rate increasing from 1.6% to 2.3%. What is most noteworthy, however, is the steep increase from three months to three years and the fact that the three-year interest rate is higher than the 10-year interest rate. This may indicate that financial markets are expecting short-term interest rates to increase rapidly, but that they may not remain there for too long. Perhaps because the financial markets fear that rising interest rates will cool the economy, and eventually force the Federal Reserve to begin stimulating once again.
On March 16th, Chinese stocks rose over 9% following a speech by Vice Premier Liu He, director of the Office serving the Central Financial and Economic Affairs Commission. During his speech, the vice-premier seemed to say all the right things.
For the first quarter of 2022, returns were mostly negative—including bond returns. As a reminder, when interest rates rise, bond prices fall. Also, the longer the bond's term to maturity, the greater that price change will be. This quarter was a textbook example with short-term treasury bonds falling 2.5%, intermediate down 4.2%, and long-term dropping 10.6%.
Stocks were also down across the board. Domestic stocks fell 4.6%, followed by foreign developed losses of 5.9%, and worst off were emerging market shares down 7.0%. Within emerging markets, however, if China was excluded the returns were less severe at -3.5%. For investors holding funds with limited China exposure, their returns looked a little better than the broader index.
Non-traditional assets fared best in Q1. Liquid alternative strategies as a group fell 1.9%, but with the help of strong performance from some long-short managers, investors could have seen positive returns in this category. Global real estate fell 3.5%, while infrastructure—which benefited from rising energy prices—increased 4.4%.