Are Fed tightening expectations overdone?
The Federal Reserve has begun raising rates as anticipated, but amid considerable global uncertainty. Lisa Hornby discusses the implications for bond markets.
The Federal Reserve (Fed) has followed through with a much anticipated interest rate hike, raising the Federal Funds Target Rate by a quarter of a percent to 0.25-0.50%. It’s the Fed’s first hike since 2018 and comes in response to multi-decade highs in inflation.
The Fed cannot ignore rising prices, but it is also hiking amid major geopolitical uncertainty and possibly slowing growth. The higher energy and food prices fuelling inflation, and exacerbated by the war in Ukraine, are likely to weigh on consumer demand. Rate hikes are aimed at curbing inflation, but will also usually impact growth too, as rising borrowing costs dampen activity.
The Fed has indicated a rapid tightening trajectory in 2022, which has caused significant rises in bond yields. But given the aforementioned factors, there are questions around how quickly and how far the Fed will be able to raise rates. A more moderate pace of tightening than expected would be supportive to bonds, with valuations now looking much more appealing following the sharp sell-off.
Here, Lisa Hornby, Head of US Multi-Sector Fixed Income, gives her views.
The following is based on a podcast which took place on Thursday, following the Fed's March policy meeting. You can listen to the conversation with Lisa in full on the Investor Download podcast by clicking the play button at the top of the page. You can subscribe to the Investor Download wherever you get your podcasts. New shows drop every Thursday at 1700 GMT.
The Fed raised rates and hinted that they could raise at every meeting this year and maybe even four times next year. Was that more aggressive than expected?
The Fed did manage to be even more hawkish than the market had already been expecting, and we saw in a jolt higher in the 2-year yield. This was quite a feat because the market has gone through great lengths to price in an aggressive rate hiking cycle over the next year.
Before the Fed meeting the market expected as many as seven 25 basis point hikes over the next 12 months, and now expects just over eight, as a result of the Fed's communication.
Does the bond market investor believe the Fed will knock down inflation, irrespective all other considerations out there right now?
Inflation-linked US Treasury bonds had been “pricing in” pretty significant levels of inflation, 2.75-3% over a five to 10-year period. They contracted a bit in response to the meeting, with a slight reduction in expected inflation over the next several years, suggesting the market does believe the Fed can get a handle on it.
Those markets also suggest a return to more normal levels over time is expected. Nominal yield curves (which plot government yields across maturities) are also very flat, suggesting little concern about structurally higher levels of inflation. So I think the market does believe the Fed can conquer this. The big question is can they conquer it without triggering a US recession.
What is the yield curve telling us at the moment?
The yield curve shows the relationship between short-maturity and longer-maturity yields, plotted along a curve. What we typically see is the short-end of the market is closely tied to Fed policy. So, as the Fed is raising rates, short-end yields tend to rise with them.
What typically also happens is as the short-end rises, longer-maturity yields fall. Long maturity bond yields, typically correlate quite highly to longer-term growth and inflation expectations and if the Fed is tightening, that is typically going to weigh on longer-term inflation and growth.
The yield curve has flattened dramatically over recent months. The difference between the 10 and 2-year US Treasury yields has fallen from 77 to below 25 basis points year-to-date. This suggests the market does see Fed tightening bringing inflation under control, but that it will also bring down growth.
What do you make of the Fed’s growth and inflation forecasts?
The Fed forecasts growth to slow to about 2.8% in 2023 and 2.5% in 2024 and for inflation to fall back to about 4% by year-end, from 7% currently. These projections look decidedly optimistic. The most striking perhaps, is the forecast is that even as growth slows down, unemployment is going to remain unchanged at very low levels for a long period of time.
That does not seem consistent with history where a slow down in growth has tended to result in a rise in unemployment. The Fed is trying to convey a very positive message, that there's plenty of room to hike rates and bring inflation down, but still maintain a rosy economic backdrop. It is unlikely to be that simple.
That “soft landing” scenario was more likely before Russia invaded Ukraine. But with that further fuelling elevated commodity prices, the Fed's job is even harder. Inflation is going to go even higher, so they need to respond, but higher inflation will be a constraint on growth via the US consumer and on businesses as well. A US recession in the next 12 months is not our base case at this juncture, but the probability or risk has risen.
A lot of the drivers of inflation right now are out of the Fed’s control, rising oil prices because of the war in Ukraine, supply chain disruptions, supply/demand imbalance in US labour, how do they square that circle?
When you only have a hammer, everything looks like a nail and that's the conundrum facing the Fed at the moment. Fed policy isn't going to solve supply chain issues. Inflation is clearly the problem, while employment is very healthy. So they're doing something rather than nothing and they're under enormous political pressure to get inflation back in the box. Tightening financial conditions is probably the right thing to do, but it's not going to fix many of the real underlying problems.
Investors are losing money in credit and bonds, how much more pain can they tolerate, particularly in their core bond portfolios, which are not protecting them from weakness in equities?
The move in fixed income has been dramatic. Retail investors could withdraw money when they see their quarterly statements at the end of March. Typically though, when you see such dramatic losses in bonds, the best thing to do is stick with it. A lot of bad news is in the price now – more than eight rate hikes over the 12 months.
Two-year investment grade corporate bonds are now yielding 3%. That's a decent return on a very short duration instrument, with lower sensitivity to rate moves, in high grade bonds. That is also potentially attractive if you're worried about volatility. Historically, 1-3 year investment grade US corporate bonds, on a total return basis have only had a materially negative annual return once over the last 45 years and that was in 2008. At this point, yields would mathematically have to rise another 150 basis points approximately, from already elevated levels, for those bonds to incur capital losses. That is a significant good cushion and looks really favourable to a year ago when yields on those bonds were approximately 0.5-0.6%.
How do you generate income in today’s bond markets?
The happy answer is that it is getting easier. Coming into this year there wasn’t much opportunity. Not only are yields now higher, but credit spreads have widened materially, closer to or even above their median relative to their historical range. Valuations have really improved particularly certain spots in the investment grade market.
High yield now has a 6+% yield, but there you have to decide where the economy will be in the next 12 to 18 months. If you see a recession, the front-end of the investment grade market is an appealing, relatively low risk place to hide and wait for potentially a better opportunity in spreads. If you think we are going to see a soft landing, then high yield looks pretty attractive.
The key thing is picking the right credits and particularly companies that are reducing debt on their balance sheets, also that are less cyclical, with more defensive characteristics. There is more volatility to come, but on a long-term view there is opportunity in these areas.
Is there a risk the Fed tightens so much as to damage the health of the economy and disrupt market stability?
That is certainly the risk and that is why markets have had such a tumultuous (and negative!) period this year. There is a scenario, however, where a soft landing is achieved, which would likely require inflation to peak in the next couple of months. We certainly think inflation is past its worse levels and starting to trend in the right direction, lower!
Recent data showed a month-on-month drop in the producer price index, albeit it is still elevated. So we are starting to see encouraging indications in the data, particularly excluding food and energy, though these are big components. But we are starting to see some tentative evidence of supply chain issues abating and, with prices higher, some demand destruction, which support the idea that inflation peaks in the next couple of months.
That would allow the Fed to temper its pretty aggressive hawkish rhetoric. In this event, they wouldn’t have to hike seven times in the next seven meetings. That would afford scope for the bond market, particularly the short and intermediate part, to perform better. And growth slows, but doesn't actually tip into a recession. Gas prices are off the highs, and there is always a chance of conclusion on the Russia-Ukraine war that would support this thesis. Assuming a soft landing would imply a good opportunity in risk markets, not just fixed income, but equities too.