Seven is the number
There are seven opportunities for the US Federal Reserve to raise interest rates this year, assuming scheduled meetings are the most opportune time to make such decisions. That’s a more aggressive pathway than is currently priced in and it would mean a more rapid tightening cycle relative to what we saw in 2015-2018. As Fed Chairman Powell said, this is a very different economy to that period. Real short rates became positive in 2018. To achieve the same, should we expect the Fed Funds to climb above 3.0% eventually? That may be stretching it, but the Fed’s messaging hints that there is more to come than what is in the price today.
It’s probably best at this stage to have as a default expectation (not a forecast) that the US Federal Reserve (Fed) could increase its key policy interest rate by 25 basis points (bps) at every scheduled meeting this year. The next two meetings are on March 16th and May 4th with the market having sight of inflation numbers for February and March by the time of each meeting. Given that we expect year-on-year inflation rates to remain very elevated, the Fed would have every justification to increase rates on those dates. By the subsequent meeting on 15 June, we will know what the April and May inflation numbers look like. By then, the expectation is that the year-on-year inflation rates will have started to fall as a result of base effects and some easing of supply and energy price pressures. The Fed could pause if the numbers are moving in the right direction or continue with rate hikes if inflationary pressures are still very evident. The unemployment rate could be near to its pre-pandemic low of 3.5% by then, giving the Fed additional reasons to hike. By the time of the September and November FOMC meetings, there will be evidence of how the markets and economy have responded to higher short-term interest rates. The Fed Funds rate could be already be at 1.25% by then. But in real terms it would be very negative still given our expectation of 2023 inflation averaging just under 3%. As such, another 2 or 3 rate hikes by year-end may then be on the cards. Prepare for the worst because what we are talking about is not actually that bad (in the context of where we started on the eve of the pandemic). A hike every meeting would mean 2.0% by year-end and a much different outlook for 2023 where the peak in the rates cycle would be very much in view.
In the wake of last week’s FOMC meeting and subsequent comments from Chairman Powell, the market has almost priced in the above scenario. Two-year Treasury bond yields are now trading at 1.2% which is 100bps higher than the average level for 2021. The pricing in of a more hawkish Fed has generated a further flattening of the yield curve with the spread between 10-year and 2-year bonds now down to 0.62%, a decline of close to 100bps from the steepest level it reached last year. For income focussed investors with US dollar exposure, the short-end of the curve is attractive now – especially compared to European fixed income where German 2-year government bond yield is still a negative 60bps. No wonder the dollar is strong, heading to a sub-$1.10/Euro level in the short-term.
Flatter curve, higher yields
A flattening curve is typical of a rate hiking cycle. In the run up to the peak in the interest rate cycle at the end of 2018, the US curve continued to flatten even with 10-year Treasury yields rising. The core strategy for bond investors is to be more weighted to short-duration exposure until there is confidence that the Fed has done raising rates and, for the more sophisticated, combine that with a flattening bias in a full maturity bond portfolio. While the market might move towards pricing in a move at every FOMC meeting, that doesn’t necessarily mean it has got all the rate hikes coming in the bag. It would be very unusual for the market to price in the full extent of the tightening cycle before the first hike in rates. There is upside potential for yields across the curve.
Stock and flow
The big unknown around the future shape of the yield curve and the level of longer-term interest rates is the balance sheet. The Fed is winding down its monthly purchases of Treasury and Agency bonds right now and Powell said that it will begin to reduce the size of the balance sheet later this year. However, there are few details about what that will look like in terms of timing, duration and magnitude. However, both the flow and stock of bonds held by the Fed will be turning negative at some point.
Risk premiums higher?
This is super important. Risk premiums across all asset classes have fallen in the quantitative easing (QE) era as central bank activity basically reduced the risk of higher interest rates and provided plentiful liquidity. Portfolio re-balancing benefitted risk assets, allowing ex-ante credit risk and equity risk premiums to come down. Call it financial repression if you want. Looking forward, does the reverse happen? Do risk premiums go up as the supply of risk-free assets increases more than what would be the case in the case of business as usual (i.e. governments issuing bonds to cover deficits and refinancing)? Conceptually one can’t help thinking this will push risk-premiums up, meaning a higher term premium in rates markets, wider credit spreads and default risk in credit and lower price-earnings multiples in equities.
The caveats to this ultra-bearish view are important. The first is that balance sheet reduction is a policy option. The Fed, and other central banks have full control over how quickly and by how much they reduce their balance sheets. If they sense that there are negative externalities, they will change the policy. Second, the timing is unclear, and it may be that this happens in a very gradual way. The third is that it would need to be a global development to have the biggest impact on yields. All major central banks have been engaged in QE at the same time in various periods since 2009 – including during the pandemic. That quantum of bond buying by central banks brought down yields everywhere. It might need them all to be engaged in quantitative tightening at the same time to generate a broad, permanent increase in yields. The ECB and Bank of Japan will be watching the Fed’s experiment closely. On balance, if balance sheet reduction happens over the next five years or so, yields probably will be higher but the path seems very uncertain at this stage.
Volatility creates opportunity
Meanwhile the immediate focus is the valuation adjustment taking place across markets. Volatility always seems to create a greater dispersion of views amongst market commentators – some arguing it’s the time to buy, others sharpening their bearish forecasts emboldened by double digit declines in equity indices. There are some saying the Fed’s policy will be overkill, bringing forward a recession. Others counter this by saying much more will be needed to compensate for the inflation that has been driven by massive fiscal and monetary stimulus combining with global supply shortages. The best advice is to distance oneself from a lot of the hysteria (keep reading this though, obviously) and, think about what your investment targets are. If preserving capital is key then cash and short-duration assets, quality and low-volatility stocks and real estate should help. If growth opportunities are to be seized, then making a judgement about emerging markets and when the valuation of growth stocks has gone far enough is a key one. The good thing about higher yields, is higher yields. Income expectations can be given more importance in planning asset allocation again.
Investors have lost money so far in 2022. But we know why. The US central bank is doing what it is supposed to do by responding to inflation which is way above its target. The extent of the inflation overshoot is probably going to be transitory, but the landing place will still be above 2%. The Fed knows it can’t change supply side dynamics, but it can influence credit decisions through the price of borrowing. They key to when the Fed stops will be the confidence it has in the transmission of monetary policy. So far, the transmission process is working – financial conditions are tightening through higher borrowing costs, lower asset prices and a stronger exchange rate. A hike every meeting this year will be tough but the more the Fed’s policy stance is reflected in financial conditions, the quicker the tightening cycle will be over.