Quick Guide: Why Did the Equity Market Crash?!

Intro:

Global stock markets have experienced another brutal week. Inflation fear and soaring bond yields are bursting the bubble of the rocketing stock market. Yes, this is a finance article, but don’t leave yet! I will try to break down the concepts for you step by step.

Quick Guide: Why did the Equity Market Crash ?!

Global stock markets have experienced another brutal week. Fear of rising inflation and soaring bond yields are some of the concerns that signals the bursting bubble of the rocketing stock market. Looking at the Hong Kong stock market, the Hang Seng index has dropped over the past 5 consecutive trading days.

Many people talked about the reason behind the drop: a rise in the U.S. treasury yield from 1.2% to as high as 1.6%. This concept may appear hard to understand at first, but I will try to break down the technicalities with simple terms in this article and provide a quick explanation of this phenomenon!

Part 1: General Understanding

Before going into details, let’s first learn a bit more about the ‘very important organisation’ that regulates the U.S economy.

Federal Reserve (FR)

The FR has 2 responsibilities (also called Dual Mandate) .

1. To keep the unemployment around the natural rate. Usually 4%. But due to COVID, the unemployment rate in the U.S. has increased to 14%. Many thought that the reason the Federal Reserve released stimulus is to save the economy. But this is wrong. It just happened that the employment rate will drop every time the economy is going down. The purpose of easing or stimulus is only to reduce unemployment, NOT to save the economy.
   

2. To keep the inflation rate around 2%

This job of FR is equally important, and it goes hand in hand with the unemployment rate. As we know, too much monetary stimulus package will cause inflation (People have more money to spend, so they will push the price of general goods up in the country). Therefore the FR needs to find a balance between maintaining a low unemployment rate without letting inflation soar too high.

Part 2: What is the treasury yield?

Now let’s move on to talk about the relationship between U.S. Treasury Bill (t-bill) & the Inflation

T-bills are very sensitive to inflation. To quickly explain the concept of the T-bill:

Think of it as a rate of interest that the U.S. government has to pay you when they borrow money from you.

Imagine you lend the government 100 USD by purchasing a t-bill, with a yield of 2%. You will receive 2 USD by the end of Year 1, and another 2 USD at the end of Year 2… etc. With 2 USD, you can buy a sandwich. However, if the country is experiencing inflation, you will not be able to buy the sandwich at 2 USD anymore. Therefore, you will want a higher yield from the t-bill.

Part 3: Why did the stock market soar last year?

As COVID was being gradually brought under control, many analysts predicted that the US economy would recover. Meanwhile, don’t forget that the US has printed an enormous amount of dollar bills last year! Although FR feared that this may cause inflation, reality proved them wrong. Most people used the money to buy risky assets such as Bitcoin and stocks instead of spending them in the real economy. This is because they need to search for yields elsewhere than bonds. This also explains why the stock market was booming even at the peak of COVID as shown in Dow Jones, Nasdaq, SSE composite and Hang Seng index. However, as the economy starts to recover now, people will spend more money on consumer goods.

Part 4: How does a rise in t-bill yield cause a stock crash?

Remember that we just talked about the enormous amount of money printed last year, which means the amount of demand from consumers will also be enormous. And the driving consumption in the economy will push the inflation rate up to a new high.

What will FR do when there is inflation? Well, it is their job to maintain the inflation at around 2%. They will tighten the monetary control, meaning less money and less subsidy given to make you spend less.

In that case, less money will be poured into the equity market because they are considered risky assets.

Note here, one of the differences between t-bill and equity is that the chance of you getting the promised rate from t-bill is 100%, there is nearly no risk in investing. Whereas in equity, there is a chance that you will lose the money. When the t-bill yield is high, people will be inclined to invest in them to get a 100% guaranteed rate. Thus, risky assets become less attractive.

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