With inflation at multi-decade highs, a tightening of monetary policy appears inevitable. Since November, a growing number of central banks—most prominently the Bank of England—have begun to raise rates, and the Federal Reserve is expected to follow suit in March.
There are, of course, concerns about the withdrawal of monetary stimulus and its potential adverse effect on financial markets and the economy as a whole. However, with rate hikes already firmly priced in, we believe the far greater risk is that the central banks do not deliver on what is expected. And that would most likely result from a resurgence in COVID cases, which would be bad news for transportation and hospitality companies, whereas biotech firms and online entertainment providers thrive in such an environment. Commercial banks, meanwhile, will be hit directly by lower future levels of interest rates and an accompanying drop in bond yields.
The past four months saw a momentous shift in monetary-policy expectations. Since the FOMC meeting on September 21-22, 2021, the likelihood of a Fed rate hike in March implied by short-term interest-rate (STIR) futures has gone from virtually non-existent to near-certain. The left-hand chart below shows the estimated probabilities for different Fed funds target rate levels, based on contracts with a March 2022 expiry traded on the Chicago Mercantile Exchange (CME). The blue line represents the probability that the target rate is still 0-0.25% after the FOMC meeting on March 16. At the end of September, it was still close to 100%, but has since declined rapidly. The final push was provided by the minutes from the December meeting, published in early January, which explicitly noted that “it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated.”
Futures-implied probability for March Fed rate hike (left) and US Treasury yield curves (right)
Over the same period, US Treasury yields also shifted upward across all maturities, as shown in the curve chart on the right. The upsurge was most pronounced around the 2-year and 3-year points, which rose by 75-80 basis points.
The Bank of England, meanwhile, startled market participants twice in a row, first by not raising its base rate as expected in November, and then doing so in December, despite the expectation that the move had been postponed until February 2022. The next 0.25% raise is still penciled in for February 3, according to sterling overnight index average (SONIA) forwards and Gilt yields shown in the left and right charts below, respectively, plus another 75 basis points expected by the middle of 2023.
SONIA forward rates (left) and UK Gilt yields (right)
So, what will happen if these anticipated rate hikes do not materialize?
We conducted a stress test to simulate the likely impact of the rate movements being priced out of the market. The easiest and most direct way is to shock the interest-rate futures, which either explicitly reference those central-bank rates or the market benchmarks closest to them. For example, if traders would no longer expect the Federal Reserve to raise its target-rate corridor on March 16, the price of the CME 30-day Fed funds future with a March expiry would rise by approximately 0.25 points1.
In the UK, the closest, most liquid instruments would be 3-month SONIA futures traded on the Intercontinental Exchange (ICE). The current expectation is that, at the end of the year, the BoE base rate will be 100 basis points higher than its current level of 0.25%. If all these rate hikes were to be suddenly priced out, the price of the December future contract would climb one point.
The charts below show the simulated returns of selected sectors within the STOXX® USA 900 (left) and the STOXX® UK 180 (right) for each described scenario, respectively. The transitive stress tests, performed in Axioma Risk™, Qontigo’s portfolio risk management platform, were calibrated on daily returns since September 21, 2021—the date of the FOMC meeting that heralded the recent significant revision of monetary-policy expectations.
Simulated returns for selected US (left) and UK (right) equity sectors
The analysis shows that either scenario would negatively affect most sectors, with the overall US and UK markets projected to fall by 3.6% and 1.7%, respectively. As we noted above, the recent reevaluation of monetary-policy expectations has led to significant rises in Treasury yields. If rate hikes get priced out, these yield increases are likely to revert. As the profitability of commercial lenders tends to be linked to the general level of interest rates, this would be bad news for the banking sector, resulting in potential losses of more than 10%.
Energy companies would be similarly affected, but here the reason is an underlying drop in the oil price of 20% in the Fed scenario and 10% if the Bank of England does not act. The most likely reason for either central bank not to raise rates would be a slower-than-expected economic recovery, due to a renewed upsurge in COVID cases. The latter, in turn, would also be bad news for the transportation (e.g., airlines) and consumer services (hotels, restaurants, etc.) sectors.
But there are also industries that can benefit from a resurgence of the pandemic. The healthcare sector seems like one of the most obvious winners, not just for its perception as a ‘defensive’ investment. Revived demand for new or improved vaccines or medications would raise the profits of the biotechnology and pharmaceutical firms that develop and produce them. A reintroduction of lockdown measures would be a boon for companies serving people who are working and shopping from home, which explains the positive performance of media and online entertainment companies, and telecommunication service providers.
Information technology is the only sector showing an ambiguous performance, with a 4.5% loss in the US and a 3.3% gain in the UK. However, digging deeper into the specific sub-sectors reveals that software service providers are more likely to benefit once more from lockdown restrictions, while hardware producers might be hit more by renewed supply bottlenecks.
With new COVID cases beginning to decline in both the UK and the US and the British government already lifting the most recent restrictions, the probability of either central bank not raising rates may seem increasingly remote. But at the same time, there is going to be little impact from the Federal Reserve and the Bank of England tightening monetary conditions as and when expected. After all, what is already priced in is unlikely to move the market very much when it actually materializes. The real risk is, therefore, the unexpected, however unlikely it may appear right now. And our analysis shows that the potential impact on certain sectors can be quite severe.
 Interest rate futures are traded in a way that the predicted rate can be derived by subtracting the quoted price from 100. For example, if the futures price is 99.45, the implied interest rate would be 0.55%.