A different kind of "taper tantrum"

October delivered the much-dreaded ‘taper tantrum’ scenario which saw yields aggressively reprice higher. However, somewhat surprisingly, risk assets hardly blinked – with major US equity indices hitting record highs.

Historically, only a surprise policy change from the US Federal Reserve (Fed) has invoked such a dramatic domino-effect repricing of rates markets, yet the Fed was mostly silent throughout October (partly due to their two-week media blackout ahead of their next meeting). The initial move higher in rates started with the Bank of England (BoE) signalling earlier-than-expected rate increases. That was quickly followed up by hawkish messaging from the Reserve Bank of New Zealand (RBNZ), and then the Bank of Canada (BOC) which announced an end to its quantitative easing program. The final straw was the higher-than-expected September quarter inflation data in Australia.

RBA throws in the towel

The market reaction to Australian inflation data was swift and severe, resulting in a six-standard-deviation move in yields for Australian three-year maturity bonds – which forced the Reserve Bank of Australia (RBA) to abandon their policy of yield curve control. The market has now factored three 25bp interest rate increases over the next 12 months into yields. Despite the RBA’s more relaxed messaging on inflation the market is expecting the RBA to respond to increased inflationary pressures. The other interesting move was the reaction of the yield curve, which ‘twist’ flattened – meaning that yields on short maturities increased but 30-year yields fell. This movement was the second-biggest curve flattening day in a decade (behind March 2020) reflecting the fact that while investors have brought forward timing of the rate increases by the RBA, they aren’t expecting any additional increases – resulting in terminal rates remaining broadly unchanged.

Inflation questions remain

These expected policy pivots are being driven by the continuing rise in inflation, which is leading many to question the assumption that inflation will be transitory rather than structural. Supply disruptions and bottlenecks are persisting and now we are witnessing an uptick in the more cyclical elements of inflation as economies reopen and pent-up demand is released. This trend is exemplified by the Employment Cost Index (ECI) in the US, which measures wage growth. The ECI is now tracking at 4.2% over the past 12 months. With wages rising we have potential to switch the cause of inflation from ‘bad’ supply-constrained inflation to ‘good’ demand-driven inflation. This could trigger additional monetary policy tightening above what is currently factored into yield curves.

Outlook

October’s developments didn’t really change our outlook. Expensive equity valuations and narrow credit spreads continue to provide elevated risks should we see any negative surprises. In a period of rising inflation markets tend to change their behaviour and correlations can shift meaningfully and rapidly. It’s this potential change in market behaviour that drove our recent reduction in our higher risk credit-based exposures, such as global high yield bonds. Their lower correlation to equities can make them a helpful diversifier, but with spreads trading at historical lows the reward for risk of holding such expensive assets is diminished due to their negative payoff asymmetry – simply put, there’s more downside than upside.

While we didn’t exactly predict the timing or magnitude of the rates sell-off, because of the above view we were well positioned. Our short duration overlay added positively to performance during October (+40bps). Prior to the CPI release we added a yield curve flattening position in Australian rates (long 30-year vs short 5-year). The higher rates move in Australia led us to close our hedging positions at the 3-year maturity and shift our long duration positions from the US to Australia – all of which added positively to performance.

Despite this volatility in rates markets, equities weren’t particularly fazed by the sharp moves. Admittedly, where rates repriced the most (i.e. the UK and Australia) equity markets lagged, but even they finished in positive territory by month-end. As we’ve become accustomed to, the US market led the move higher with the S&P500 rallying 6.9%, reversing September’s fall, as companies continue to report above expected earnings growth for the third quarter. While we are first to acknowledge that equities aren’t cheap, their potential for additional upside remains hence our relative preference for equities over credit-based assets where capital gains are more limited. It’s this continuing ‘quality’ of earnings and potential to grow into higher valuations that led us to increase our US equities exposure in October.

In summary, we continue to deploy our risk cautiously and selectively as we believe this period of market transition can continue until we have further clarity on the path of inflation and the policy responses – and that is unlikely to be known until sometime in 2022 due to ongoing supply-driven bottlenecks.

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