Fed Up? The fallout from overly sweetened monetary policy
Portfolio Managers Dan Siluk and Jason England believe that the tide may have turned and that financial markets are forcing the hands of global central banks to react to brewing inflation.
- In the face of rising inflation, markets have tested the commitment of global central banks to highly accommodative monetary policy.
- Just as investors have gotten the Reserve Bank of Australia to abandon yield curve control, other policy hallmarks of this era are also likely to be called into question.
- With volatility elevated and rates likely rising, bond investors can deploy a range of measures to help achieve the objectives of capital preservation and generating attractive returns.
Fed Up is a 2014 documentary about the food industry and how “Big Sugar” (among others) is responsible for the poor health of everyday Americans. It’s not a stretch to reference this film when speaking of the Federal Reserve (Fed) and central banks. Distinct parallels exist given their constant sweetening – through low interest rates and quantitative easing (QE) – of financial markets and willingness to meet any sign of volatility and drawdowns with more 'sugar' (i.e. larger policy responses to each crisis). This has created a generation of 'financial consumers' gorging on cheap debt. Yet, promises that this feasting can continue into perpetuity simply cannot be kept.
Inflation gets a vote
Fixed income investors face a particularly challenging time, as uncertainty over the global economic recovery and monetary policy entwine. Guiding investors on this journey falls in part to the (hopefully) steady hand of those in charge at the central banks, as they seek to sustain momentum of the post-pandemic economic reopening without allowing inflation to get out of hand. Adjusting the lever of QE is a delicate balance, and it’s no wonder bond markets are struggling to fully interpret the implications. For investors, the double whammy is that it comes at a time when fixed income returns are generally pedestrian, at best, with QE having kept real yields depressed for years.
The question of how persistent and at what level inflation remains is almost impossible to answer. Are we seeing reasonably constant improvement in economic data? Yes. Rising confidence in coronavirus vaccination efforts? Yes (noting the recent emergence of the Omicron strain). Border reopening plans progressing? Yes. But also impacting the pace of inflation are supply chain disruptions and the knock-on impact to the costs of goods and services. If we assume these issues resolve over time as the world continues to emerge from social restrictions and prices moderate, inflation should become more manageable.
Recent bond price action has been driven by a sharp sell-off across developed market yield curves, particularly in the front end as markets hurriedly re-priced rate hike expectations to be sooner than expected due to inflation.
Some of the fiercest moves have occurred in Australia, with the Reserve Bank of Australia’s (RBA) policy of yield curve control (YCC) – which targeted 0.10% yields on maturities up to three years – now being challenged by market participants. In late October, the April 2024 sovereign bond traded as high as 0.18%. The RBA subsequently bought AUD $1 billion of bonds, bringing the yield closer to target at 0.115%. However, at the end of the month annualised inflation, as measured by Core CPI, was 2.1% – within the RBA’s target range for the first time since 2015 – pushing yields on the April 2024 bond once again to 0.2%. The following day there was anticipation that the RBA would be back in the market, purchasing bonds to draw the yield closer to target. But instead, there was no action nor communication from the central bank. Over the next few trading sessions, yields on that bond climbed as high as 0.8%, suggesting YCC would be abandoned at the RBA’s upcoming meeting. Indeed, in early November that’s exactly what transpired. Subsequently, the yield on the three-year bond soared 91 basis points (bps) to 1.22%, while that of the 10-year rose 60 bps to 2.09%.1
We are taught that central bank policy drives markets, but increasingly it seems it is the other way around as markets have begun to challenge the ultra-accommodative stance of central banks. The RBA’s loss of its YCC target is one example. As we turn our attention to the US, could the suspicious observer conclude the Fed is ‘on hold’ until the market forces its hand?
And now the Fed’s turn?
Key economic data in the US (such as lower unemployment) have provided a tailwind to the inflation story, with QE tapering anticipated in the near term, and bond yields moving higher. Let’s not forget that in the last cycle, the Fed began to normalise its balance sheet and embark on a rate-hiking cycle when i) inflation was lower, ii) unemployment was higher and iii) the tailwind of asset returns, while still positive, was softer. Why should central banks maintain emergency level policy settings? In light of this, we believe, interest rates should continue to rise in 2022.
Charting a path for bond portfolios
Rather than fretting over a half-empty plate, bond investors should keep in mind that rising rates are not necessarily a bad development. For over a decade, we’ve all moaned about astonishingly low bond yields. Important at this juncture is the pace of rate increases, as typically, that dictates the trajectory of bond returns. In the absence of short-term surprises, investors have the opportunity to reinvest maturing securities at yields higher than what had been available only weeks or months prior. This strategy is all the more relevant for strategies biased to shorter-dated assets that can exit highly liquid positions and reallocate towards longer-dated, higher-yielding securities of similar quality. If inflation proves more persistent than expected but policy rates remain on hold, shorter-dated strategies are also less impacted by rising rates than those that have extended duration profiles.
It’s clear interest rate uncertainty and volatility can impact bond markets. Conventionally managed portfolios have struggled to maintain their defensive attributes for investors. Performance has been fairly wild and low yields have been insufficient to offset the impacts of rate moves, quickly eroding capital and driving more traditional portfolios to not-immaterial losses in the 3-5% range.
COVID-19 and potential new waves or new strains of the virus will remain a cloud hanging over investors’ minds until vaccination and efficacy rates are meaningfully higher. We are beyond the peak in fiscal stimulus, with governments largely satisfied that they were able to avert a materially longer and deeper period of low growth. Central banks now have the unenviable task of managing the removal of ‘candy’ from outstretched hands. Do they continue to do so slowly, or does inflation force faster ‘dieting?’ If it’s the latter, what new tantrums are around the corner? Hopefully the only upset will be among the ungrateful kids spitting the Christmas dummy as supply chain constraints impact delivery of this year’s must-have toys. To placate them, just give ‘em sugar… seems to work for markets.
1All market data sourced from Bloomberg.
Monetary policy/stimulus/tightening: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. This stance is also known as accommodative policy. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.
Quantitative easing (QE): An unconventional monetary policy used by central banks to stimulate the economy by boosting the amount of overall money in the banking system, typically through purchasing assets with money created by the central bank.
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility.
Yield: The level of income on a security, typically expressed as a percentage rate.
Yield curve: A graph that plots the yields of similar quality bonds against their maturities. In a normal/upward sloping yield curve, longer maturity bond yields are higher than short-term bond yields. A yield curve can signal market expectations about a country’s economic direction.
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