Portfolio Manager Jason England explains why the Federal Reserve (Fed) is prioritising the need to reel in inflation that has proven to be anything but transitory.
Key Takeaways
- By pulling forward its normalisation programme, the Fed has acknowledged that its highest priority is taming the rising prices that are inflicting pain on American households.
- Given myriad sources of inflation – with some typically less responsive to higher rates – we believe the Fed has yet to reach “peak hawkishness.”
- Higher front-end rates accompanying a flatter yield curve may be welcome for investors seeking liquidity and yield, but persistent inflation and a small term premium have raised the risk for longer-dated securities.
If Wednesday’s announcement by the Federal Reserve (Fed) proves anything, it is that the US central bank continues to prioritise forward guidance in signaling the future path of monetary policy to reassure financial markets that its hands remain firmly on the tiller during a period of economic uncertainty. After its botched call on transitory inflation, Chairman Jerome Powell and company have their work cut out for them.
As had been telegraphed, the Fed raised its benchmark policy rate by 50 basis points (bps) for the first time in over two decades. Not much else can create a sense of urgency than 8.5% year-over-year inflation. Despite this move, we still believe that the Fed – and other central banks – have yet to reach peak hawkishness. This current bout of inflation, in our view, has too many unpredictable sources to simply be placed back in the bottle by raising policy rates in a circumspect manner. Pandemic-related supply dislocations, a growing economy, accelerating deglobalisation, the war in Ukraine and the historic amount of liquidity created out of thin air to cushion the blow of what turned out to be the short-lived recession have all contributed to the historic run-up in prices across much of the global economy.
A change of pace, not destination
In his comments, Chairman Powell acknowledged as much and set the table for pulling forward even more of its normalisation programme. Among these are likely two more 50 bps rate hikes and the rapid ramping up of balance sheet reduction – ultimately topping out at $95 billion monthly – by not reinvesting maturing Treasury and mortgage securities. This is not to say that the Fed has changed its final destination. At its March meeting, after all, it actually lowered its expectation for the neutral policy rate from 2.5% to 2.375%. But given the lagging effect of monetary policy along with inflation at multi-decade highs, we believe the Fed has made the right call by pulling forward normalisation and then closely monitoring data over the latter half of the year to watch how prices and economic growth respond.
Evidence, thus far, is that the Fed’s about-face over the past few months is finding receptive ears in financial markets. We see that, foremost, in a flattening yield curve. Over the course of 2022, the yield on the 2-year US Treasury has risen 191 bps to 2.64% (after Wednesday’s fall in yields) as the market priced in near-term policy rate increases. Meanwhile, the yield on the 10-year has climbed by a less dramatic 141 bps, to 2.92%. We interpret this as the market seeing the Fed having a fighting chance in piloting the US economy toward a soft landing. If the Fed had lost all credibility with investors, we’d likely be seeing a spread between 10-year and 2-year Treasury yields at a level higher than the current 28 bps. Other market-based data send the same message. Inflation expectations based on Treasury Inflation-Protected Securities (TIPS) have fallen from 3.73% in late March to 3.24%. Over a 10-year horizon, TIPS imply a 2.88% annual average, again, off its recent peak. Of note: both rose slightly post the Fed announcement.
Interpreting the decision through a fixed income lens
The flattening yield curve has changed the landscape for bond investors. While higher yields on shorter-dated maturities may be a welcome development for those who have long awaited the chance to generate higher returns on more liquid instruments, the absence of what we consider an appropriate term premium on longer-dated Treasuries reduces the allure of these securities at present. This is especially true given the current elevated level of inflation whose ingredients – namely supply disruptions – include sources that may not be responsive to higher policy rates.
Looking forward
Like the Fed, we’ll be closely watching for signs of inflationary pressure subsiding over the next several months. This will likely take time and much depends upon supply constraints and labour shortages being resolved. It remains our view that the market has likely been too aggressive in estimating the number of rate increases the Fed will implement over the next year. This is the Powell Fed, after all, with a history of erring on the side of dovishness. But with inflation at multi-decade highs, dovishness has become a relative term. Given the tight labour market, the Fed has the latitude to prioritise taming painful levels of inflation for American households. Until that’s achieved, any bias toward maintaining growth will likely take a back seat.
Futures markets presently see roughly the equivalent of eight additional hikes in 2022. In the immediate wake of Chairman Powell’s hint that an even more hawkish 75 bps increase is likely off the table, the 2022 Treasuries rout already lost some steam as the 2-year yield fell by as much as 25 bps on Wednesday afternoon. A more methodical path to policy neutrality, in our view, will likely lead to lower volatility on the front end of the yield curve than what investors can expect with longer-dated maturities.
And in keeping with recent tradition, all investors should stay tuned to additional forward guidance to glean how the Fed, itself, is assessing the trajectory of inflation and other risks to the economic recovery.
A yield curve plots the yields (interest rate) of bonds with equal credit quality but differing maturity dates. Typically bonds with longer maturities have higher yields.
Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.
U.S. Treasury securities are direct debt obligations issued by the U.S. Government. With government bonds, the investor is a creditor of the government. Treasury Bills and U.S. Government Bonds are guaranteed by the full faith and credit of the United States government, are generally considered to be free of credit risk and typically carry lower yields than other securities.
Inflation-linked bonds feature adjustments to principal based on inflation rates. They typically have lower yields than conventional fixed-rate bonds and decline in price when real interest rates rise.