Rising Inflation & Interest Rates: Culprits Behind Market Turmoil

The Villains of 2022’s Horror Show


There’s no denying that 2022 was a grueling year for investors.  It seems like everyone lost money, regardless of the investment strategy or asset class. 


Equity draw down chart for 2022

Source: Morningstar Direct


The standard explanation for this sorry state of affairs is always the same- inflation and rising interest rates.  Is it really possible that these twin villains are to blame for losses across so many different asset classes?  In this blog post we will dig deeper and explain just how inflation and rising interest rates negatively impacted so many different investments around the globe.


Consumer Price Index, Year-on-Year Change

Source: U.S. Bureau of Labor Statistics. 


Yield Curve, Change in 2022

Source: U.S. Department of the Treasury

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The Economy

We will start with the big picture.  Ever since the turn of the century, the Federal Reserve’s solution to any problem was loose monetary policy.  Whether it was the Dot-Com Bust (2000-02), the Global Financial Crisis (2007-09) or the COVID-19 Pandemic (2020), the standard response was to flood the economy with liquidity.


Classically educated economists warned that such a state of affairs could not be maintained indefinitely without unleashing the scourge of inflation.  The tipping point came after the COVID-19 Pandemic, when loose monetary policy was coupled with extremely generous fiscal stimulus.  Much to the chagrin of starry-eyed proponents of “Modern Monetary Theory”, the harsh reality is you can’t endlessly print money without it negatively impacting prices and labor markets.


Although the response was belated, the Fed is now taking the risk of inflation seriously.  While not as extreme as Paul Volcker’s inflation-busting campaign of the early 1980’s, the remedy is the same: to vanquish inflation, the Fed is intentionally cooling down the economy by tightening monetary policy.  It is an unenviable choice, but the Fed has determined that slowing the economy is the lesser of two evils.


The problem with such an approach is that it takes a fair amount of time for rate hikes to impact the broad economy.  During that time the Fed runs the risk of overshooting its target.  The goal is to slow down the economy, not cause a recession.  But given the lag in both price effects and economic activity, there is a real risk that the Fed’s rate hikes tip the economy into an outright recession.




The U.S. stock market, as measured by the S&P 500, was underwater for almost the entire year and dipped into bear market territory several times.  It is often said that stock markets are forward-looking.  If that’s the case, that means today’s investors are forecasting a cloudy future.  There are several ways in which high inflation and rising interest rates negatively impact stocks.


  • Profit margins, current. Higher production and labor costs reduce the profitability of companies across the economy. While S&P 500 companies had been enjoying record profit margins lately, valuation metrics climbed to levels only seen twice before- in 1999 and in 1929.  Record high prices for equities could not be justified in the face of decreased earnings and profitability. 


  • Future earnings, short-term. If the economy really is headed for a slow-down, it is reasonable to expect sales to slow and consumers to re-trench. This requires a further reevaluation of equity price levels.


  • Future earnings, long-term. A stock should be worth the sum of the net present value of all its future cash flows. The value of future cash flows should be reduced or “discounted” for the fact that a dollar earned today is more valuable than a dollar at some point in the future. The higher inflation and/or interest rates, the lower the value of future dollars. The same discounting of future cash flows that so negatively impacts long-term bonds will also impact equities if the earnings aren’t expected to materialize until the distant future.  This is one reason why growth stocks have fared so poorly in the recent sell-off.




Bonds have also been a casualty of rising interest rates.  Ever since rates retreated from their double-digit levels in the early 1980’s, bonds have had the wind at their backs.  Bondholders were able to have the best of both worlds- income exceeding inflation and capital preservation when equity markets sold off.  The Bloomberg U.S. Aggregate Bond index had an average annual return of 7.42% from 1982 to 2021.


Ten Year Treasury Yield vs. Bloomberg US Aggregate, 1982-2021 graph

Source: St. Louis Fed, Zephyr StyleADVISOR


Now that dynamic has reversed and the rate environment is a headwind rather than a tailwind.  In 2022 the Ibbotson US Intermediate Term Government Bond index had its worst year since the index’s inception in 1926.  The third-worst year on this list was the prior year, 2021, as the threat of rising rates started to impact bonds. 


Worst Years for bonds chart

Source: Morningstar Direct


Inflation and rising rates negatively impact bonds in a number of ways.


  • The paltry yield offered on bonds issued over the last several years is not enough to overcome the general rise in prices.
  • Moreover, the entire stream of future income payments from a bond needs to be discounted to a greater degree as interest rates rise.
  • In addition, the return of principal will also have to be discounted at a higher rate. The $1,000 par value of a bond isn’t worth as much in net present value terms if lending rates and inflation are high. 
  • Longer-term bonds are especially susceptible to these factors.


Collectively these factors are known as duration risk.  Professional bond managers are aware of duration risk.  However, for the average bond holder who viewed bonds as the “safe” portion of their portfolio, duration risk has come as a nasty surprise.



High Yield Bonds

High yield or non-investment grade bonds are doubly impacted by the current situation.  In addition to all the duration/rising interest rate risks mentioned in the previous section, high yield bonds are subject to credit risk.


During the era of low interest rates, it made sense for companies to refinance or leverage up given the fact that debt was so cheap.  However, those salad days are over and if companies need to rollover that debt, it will be at much higher levels.  Moreover, companies that issue non-investment grade debt are assumed to be in a more precarious financial position and would be more challenged in a recessionary environment.  This does not bode well for high yield debt.


Granted, there is a lot of variability across sectors and individual companies.  Some companies have healthier balance sheets and will likely be able to weather a storm.  A lot of high yield bonds were issued with liberal covenants, giving them more operational leeway. We explore the risks in high yield in more depth here.


However, as Warren Buffet famously said, “Only when the tide goes out do you discover who’s been swimming naked.”  An economic slowdown might expose those companies at risk of default or bankruptcy.   


Us Dollar


Increases in U.S. interest rates makes U.S. based investments, and thus the U.S. dollar, relatively more attractive to global investors.  The U.S. dollar had remarkable strength versus the Japanese yen, British pound, and Euro in 2022.  However, dollar strength is not necessarily a good thing.  The dollar trading near record highs has had some negative effects, including:


  • Detriment to U.S. multinational firms. Many of the large U.S. based companies that dominate the S&P 500 have significant operations overseas.  As these companies translate their overseas earnings back into dollars, they are worth less as the dollar rises.


  • Loss of value for U.S.-based investors. A similar dynamic plays out with U.S. based investors who hold assets overseas.  The value of their overseas holdings are reduced as the dollar grows in strength.  The MSCI EAFE has a year-to-date return of -14.01%, but once one removes the negative impact of a rising dollar, the MSCI EAFE in local currency terms has a return of -6.52%[1].


  • Commodity pricing. Inflation was already causing food and energy costs to spike as the world exited the Covid-19 pandemic.  Compounding this problem was Russia’s heinous invasion of Ukraine in February, as both of those countries are major producers of commodities.  The supply-side disruptions were made even worse by the fact that energy and food is frequently priced in dollars.  The “sticker-shock” of high commodity prices was bad enough for Americans.  For consumers in non-dollar countries, the price increases were worsened by the depreciated value of their home currencies.


  • Difficulty for countries pegged to dollar. Many countries maintain strict or floating pegs to the U.S. dollar.  While this policy helps maintain the stability of their own currencies, the trade-off is these countries are forced to sacrifice the independence of their own monetary policy.  If an emerging market has a poorly performing economy and a dollar-peg, they will be forced to “import” the restrictive monetary policy from the U.S.  This could be the exact opposite of what a struggling emerging economy needs.





Gold has traditionally been thought of as a store of value during difficult times and as a hedge on inflation.  If that’s the case, why didn’t gold do better in 2022?  With capital markets down and inflation skyrocketing, why is gold suffering?  The answer is two-fold.


First, gold did enjoy a healthy run-up during the Covid-19 pandemic.  Between January 1st, 2020 and August 5, 2020, gold went from $1,524 to $2,051, an increase of 34.5%.  Early movers into gold did make money, but then some investors rotated out and took profits.

Gold value over time up to today

Source: finance.yahoo.com


The more recent factor driving the price of gold down is the opportunity costs of holding gold.  One of the traditional negatives of gold is that gold has no cash flow.  Gold pays no yield.  As long as bond yields were close to zero, this factor was moot.  However, with 10-year Treasury bonds now yielding around 4%, anyone parking their money in gold must be willing to forgo the “risk free” opportunity cost of a nearly 4% Treasury yield.  On a relative basis, gold is less attractive than it was when bond yields were near zero.


The above chart clearly illustrates this relationship.  The recent high point for gold occurred on March 8th at $2,040/oz.  The this is right around the time that the Fed started raising rates.  Since then, the price of gold has moved in the opposite direction of rising rates.




One might hope that with the Fed raising short-term lending rates, an immediate beneficiary would be rates on CDs and savings accounts.  Long-suffering savers, stuck with 0% interest rates, should logically see an improvement in yields, right?


Unfortunately, that hasn’t been the case.  The big banks are in no hurry to increase their interest rate costs by offering rates more in-line with their lending rates.  The official explanation is that the banks have more than enough deposits on hand to fund their lending needs.  It would appear that interest rates in savings accounts quickly respond to cuts in Fed rates but are sticky when it comes to increases- the worst of both worlds for savers.


Housing & Real Estate


The line between rising interest rates and a drop-off in house prices is a straight one.  In less than a year the rate on a 30-year mortgage went from under 3% to over 7%, one of the largest and fastest rises in history.


30 Year fixed rate mortgage average chart up to today

Source: St. Louis Fed


This casts a pall over the housing market.  Potential buyers can no longer afford monthly payments at these higher rates.  Sellers are unwilling to mark their house prices down to reflect the new reality.  Borrowers with floating-rate mortgages will see steep increases in their monthly payments.  Current homeowners who might have considered tapping their home equity or purchasing a new upgraded home are reluctant to swap out their old low-rate mortgages for new high-rate loans.


For many families, a house is their largest store of value, dwarfing capital market investments.  The global value of housing is $250 trillion, compared to the aggregate value of equity markets of $90 trillion[1].  While it seems unlikely that housing will become a systemic crisis like it was in 2007-09, a depression in housing prices could be a long-term drag on the economy. 



Leading up to 2022, there was a ridiculous amount of hype surrounding “get rich quick” investments like cryptocurrencies, non-fungible tokens (NFTs), special purpose acquisition companies (SPACs), collectibles, and “meme” stocks.  These schemes are more akin to gambling than investing and have been in freefall over the last year.


While these various moonshots might seem like they have little in common, one can argue they are all simply examples of too much money chasing too few good ideas.  The trillions of dollars that flooded the economy during Covid-19 pandemic helped inflate these bubbles.  While certainly some money was used as intended- to replace lost wages or help with living expenses as the economy went into shock- a lot of it chased spectacular returns in speculative investments.  Now that the “free money” taps have been turned off the case for these moonshots is much harder to make.

2022 Cryptocurrency Prices, 2022

Source: finance.yahoo.com.  Prices scaled to 100 on 12/31/2021


For those market participants with a grasp of history, this is just the latest example of “irrational exuberance” fueling a speculative bubble.  Those who “invested” at the peak of the hype-cycle will likely get pennies on the dollar, if anything, as a return.  The bigger, more important question going forward is whether or not these losses will be contained to the punters or if there are spillover risks to the broader economy.



Battling the Villains into the Future


It might seem overly simplistic to pin all of 2022’s woes on the common factors of inflation and rising interest rates.  Hopefully this paper illustrated that yes, the end of loose monetary policy is the smoking gun responsible for the poor performance of equities, bonds, gold, the housing market, and the moonshots.


The “everything bull market” that followed the Global Financial Crisis was a one-legged stool, supported by easy money.  The central banks kept the party going as long as they possibly could, but eventually the punch bowl had to be taken away.  Now investors are dealing with the hangover.


Traditional portfolio construction relies on traditional asset classes to provide blended sources of return and risk mitigation through diversification.  2022 was a horror show for traditional asset classes- with nearly all suffering losses  at the same time. To the extent that elevated levels of inflation persist and/or that interest rates continue higher, returns for traditional asset classes may continue to disappoint investors.


Rising inflation and interest rates were the villains in 2022.  It is a form of market-wide risk that cannot be diversified away.  However, market risk can be hedged. Hedging market risk can be accomplished by using put options, which are inversely correlated to the underlying investment, that may provide investors true diversification in what seems like an “everything bear market.”


Options-based, hedged equity strategies offer investors a way to remain invested in the equity market, while maintaining a hedge for risk mitigation position. This approach doesn’t rely on bonds, with their high sensitivity to rising interest rates. Such strategies may provide a way for investors to navigate the risks of elevated or sticky inflation and the impacts of future interest rate hikes that may persist into 2023 and beyond.



About the Author

Marc Odo, CFA®, FRM®, CAIA®, CIPM®, CFP®, Client Portfolio Manager, is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy. His responsibilities also include producing most of Swan’s thought leadership content. Formerly Marc was the Director of Research for 11 years at Zephyr Associates.

Swan Resources & Education

Our portfolio managers and analysts are dedicated to creating relevant, educational Articles, Podcasts, White Papers, Videos, and more.

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1A bear market is technically defined as a loss of 20% or more.

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