Equity markets rose in February, despite a pullback experienced in the last couple weeks of the month. US small caps continued their trend of outperformance, but most major equity indices were positive. The real drama was in the fixed income markets, as longer-term interest rates rose and prices for treasuries fell. Capital markets, however, remained open and stable as rates for riskier borrowers remained low.
There has been a lot of discussion about the rise in interest rates on the longer end of the US Treasury curve. Many market commentators are framing the increase as a market forecast of higher inflation in the future, while others see it as renewed competition for equities and a reason for stocks to correct. We would agree, particularly as it relates to growth equities (which have the most interest rate risk), but only to a degree.
We think the back-up in rates has more to do with market plumbing issues for treasuries than anything else. There is a really wonky explanation for this, but the Cliff’s Notes version is that certain treasury buyers (banks) are unusually constrained due to some regulatory uncertainty as it relates to the size of their balance sheets.
As we write this Congress is passing another round of stimulus and the COVID vaccination effort continues. Most of the market is focusing on the re-opening of the economy and reflation. While we expect to see a pickup in inflation, we wonder how much of that winds up being transitory in nature. It is said that the cure for high prices are high prices and that may well be how this plays out over the cycle.