For financial professionals in the UK

An easy decision, but the US Fed watches for gathering clouds

Jason England

Jason England

Portfolio Manager


28 Jul 2022

Portfolio Manager Jason England explains why persistently high core inflation likely means monetary policy has yet to reach peak hawkishness, despite initial signs of a cooling economy.

Key takeaways

  • As it continues to prioritise fighting elevated inflation, the US Federal Reserve (Fed) raised its benchmark policy rate by another 75 basis points.
  • The Fed appears to be tolerating signs of a cooling economy as it recognises the imperative of regaining credibility and taming generational-high inflation.
  • While longer-dated yields are likely capped as they signal a slowing economy, we believe shorter-dated yields may surprise markets to the upside as the Fed front loads additional rate hikes.

As had been widely telegraphed, the Fed raised its benchmark overnight lending rate by 75 basis points (bps) on Wednesday. We consider this move necessary as the Fed has been forthright in its prioritization of taming multidecade-high inflation. In contrast to May’s 50 bps hike and June’s 75 bps increase, the central bank is now having to deal with rising tension between uncomfortably high inflation and incipient signs of a slowing economy. Still, after having misdiagnosed the malady of persistent – and accelerating – inflation during the latter half of 2021, Fed officials are not likely to take their eye off the ball until there is clear and convincing evidence that rising prices are moderating. With headline inflation – which inordinately effects the purchasing power of a large chunk of the U.S. population – still above 9.0%, we are not there yet. Given this, despite 225 bps of hikes thus far in 2022, we still believe that U.S. monetary policy has yet to reach peak hawkishness.

Tempering forward (mis)guidance

The past year has provided ample evidence that the Fed’s objectives of providing forward guidance and being data dependent can, at times, be incompatible. Last December, the Fed’s own estimate of where its policy rate would reside at year-end 2022 was 0.875%. Fast forward seven months and it has already crested 2.50%. The data won out. Forward guidance may have worked during the decade following the Global Financial Crisis – a period characterized by doggedly low inflation – but not during an era of historic fiscal and monetary expansion.  While – as the Fed pointed out– continued supply constraints and the war in Ukraine have contributed to inflation, a considerable amount is owed to higher aggregate demand.

If the recent shift in rhetoric is any indication, Fed officials have learned their lesson and now place greater emphasis on data over maintaining a preordained path laid out by earlier guidance. In addition to keeping policy properly calibrated, the ascendency of data, in our view, should have the added benefit of helping the Fed repair its damaged credibility. That said, we believe the Fed will move in an orderly fashion and avoid overreacting to any one data point. The U.S. economy is remarkably complex and there can be considerable noise in higher-frequency data.

Speaking of data points

The past three rate decisions were slam dunks. Consumption was strong as the economy continued its emergence from the pandemic and household finances were buoyed by a raft of government programs. By many measures the U.S. economy remains healthy. Even the first quarter’s annualized gross domestic product of -1.6% can be positively spun as the contraction was owed to a boost in imports from purchase-happy consumers – itself a sign of a recovering economy. Still, overall consumption has slowed from its post-lockdown peak. Given consumers’ commanding share of the economy, their willingness to put up with higher prices across major categories – and increasingly higher financing costs – bears close monitoring.

Other data indicate that higher rates along with other tightening measures may be starting to bite. Monetary policy tends to have a lagging effect and while it’s only been four months since the Fed began raising rates and reducing its balance sheet, this entire cycle has taken on a truncated nature. Given the speed of the recovery and the degree to which aggregate demand – and inflation – overheated, so too may the dampening effects of tighter policy arrive sooner than anticipated.

Evidence on that front is beginning to emerge. Core inflation has fallen from 6.5% to – an albeit still painful – 5.9% and headline inflation – at 9.1% – may eventually follow suit given the 17% decline in the price of West Texas Intermediate oil from its recent peak. The labor market is also showing signs of losing steam as the four-week average of initial weekly jobless claims has risen from 170,000 to 241,000. That level is still indicative of a healthy labor market but given the degree to which jobs are used as a lever to calibrate the economy to changing conditions, this figure also merits further observation.

Core consumer price index (CPI) dips; will headline follow suit?
Despite recent declines, core inflation remains worryingly elevated and we believe this could lead to more restrictive policy than what is already priced into markets, should it not begin to subside.

Source: Bloomberg, as of 27 July 2022.

The curve reacts

Bond prices have been working overtime to reflect investors’ expectations for the future path of policy rates and recent economic developments. These myriad signals are manifested in the changing shape of the U.S. Treasuries yield curve. Plummeting yields on longer-dated bonds indicate that the market is taking the Fed at its word that it will not take its foot off the pedal until confirmation that inflation is receding toward the central bank’s preferred range. We share this view and believe that, in contrast to only a few months ago, longer-dated Treasuries may prove less volatile over the near- to mid-term, with the yield on the 10-year note likely capped at 3.0%.

U.S. Treasuries yield curve fluid
While longer-dated maturities had exhibited higher volatility, we believe shorter-dated bonds how have greater potential for price swings until a clearer picture on the path of core inflation emerges.

Source: Bloomberg, as of 27 July 2022.

The path of shorter-dated yields over the next few months may be less certain. The market has given the Fed a chance to regain credibility, and to reward that trust the central bank won’t stop tightening until inflation has been defeated. Consequently, we believe that the Fed will front load future rate increases. This aligns with our view that policy has yet to reach peak hawkishness. Futures markets currently imply the upper bound of policy rates reaching 3.5% in December – the equivalent of four more 25 bps increases and roughly the same level it was at end of June. Even if this is where the overnight rate ultimately resides, we believe it may be reached sooner than later – a view at odds with current market pricing – to allow tightening conditions to take full effect before the Fed decides how to proceed.

With the market giving credence to the Fed’s ability to reel in inflation, we believe that investors should reconsider exposure to more rate-sensitive bonds. These securities were punished earlier in the year as investors grimaced that the Fed may once again be behind the curve with respect to inflation. In contrast to much of the pandemic era, yields have reset at levels that have the potential to offer higher income streams and greater diversification.

While this meeting was fairly predictable, we believe September’s conclave could be considerably more impactful. The Fed will have several more weeks of data to decipher and we will watch closely as to whether additional signs of an economic slowdown shift the balancing act from its current preference of taming inflation toward possibly growing concerns of igniting a labor market recession.

 

Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.

Headline inflation is a measure of the total inflation within an economy, including commodities such as food and energy prices (e.g., oil and gas), which tend to be much more volatile and prone to inflationary spikes.

Gross domestic product measures the value of the goods and services produced in the economy.

Aggregate demand is a measurement of the total amount of demand for all finished goods and services produced in an economy.

Core inflation excludes food and energy prices because they vary too much from month to month.

Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics.

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.

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.

The overnight rate is the rate at which banks lend funds to each other at the end of the day in the overnight market.

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

 

Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

 

The information in this article does not qualify as an investment recommendation.

 

Marketing Communication.

 

Glossary

 

 

 

Important information

Please read the following important information regarding funds related to this article.

Janus Henderson Capital Funds Plc is a UCITS established under Irish law, with segregated liability between funds. Investors are warned that they should only make their investments based on the most recent Prospectus which contains information about fees, expenses and risks, which is available from all distributors and paying/facilities agents, it should be read carefully. This is a marketing communication. Please refer to the prospectus of the UCITS and to the KIID before making any final investment decisions. The rate of return may vary and the principal value of an investment will fluctuate due to market and foreign exchange movements. Shares, if redeemed, may be worth more or less than their original cost. This is not a solicitation for the sale of shares and nothing herein is intended to amount to investment advice. Henderson Management SA may decide to terminate the marketing arrangements of this Collective Investment Scheme in accordance with the appropriate regulation.
    Specific risks
  • An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
  • When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise. This risk is generally greater the longer the maturity of a bond investment.
  • The Fund invests in high yield (non-investment grade) bonds and while these generally offer higher rates of interest than investment grade bonds, they are more speculative and more sensitive to adverse changes in market conditions.
  • Callable debt securities, such as some asset-backed or mortgage-backed securities (ABS/MBS), give issuers the right to repay capital before the maturity date or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the fund may be impacted.
  • The Fund may use derivatives towards the aim of achieving its investment objective. This can result in 'leverage', which can magnify an investment outcome and gains or losses to the Fund may be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
  • If the Fund holds assets in currencies other than the base currency of the Fund or you invest in a share/unit class of a different currency to the Fund (unless 'hedged'), the value of your investment may be impacted by changes in exchange rates.
  • When the Fund, or a hedged share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency, the hedging strategy itself may create a positive or negative impact to the value of the Fund due to differences in short-term interest rates between the currencies.
  • Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
  • Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
  • The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
  • The Fund invests in Asset-Backed Securities (ABS) and other forms of securitised investments, which may be subject to greater credit/default, liquidity, interest rate and prepayment and extension risks, compared to other investments such as government or corporate issued bonds and this may negatively impact the realised return on investment in the securities.
    Specific risks
  • An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
  • When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise. This risk is generally greater the longer the maturity of a bond investment.
  • Callable debt securities, such as some asset-backed or mortgage-backed securities (ABS/MBS), give issuers the right to repay capital before the maturity date or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the fund may be impacted.
  • The Fund may use derivatives towards the aim of achieving its investment objective. This can result in 'leverage', which can magnify an investment outcome and gains or losses to the Fund may be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
  • If the Fund holds assets in currencies other than the base currency of the Fund or you invest in a share/unit class of a different currency to the Fund (unless 'hedged'), the value of your investment may be impacted by changes in exchange rates.
  • When the Fund, or a hedged share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency, the hedging strategy itself may create a positive or negative impact to the value of the Fund due to differences in short-term interest rates between the currencies.
  • Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
  • The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
  • The Fund invests in Asset-Backed Securities (ABS) and other forms of securitised investments, which may be subject to greater credit/default, liquidity, interest rate and prepayment and extension risks, compared to other investments such as government or corporate issued bonds and this may negatively impact the realised return on investment in the securities.
Janus Henderson Capital Funds Plc is a UCITS established under Irish law, with segregated liability between funds. Investors are warned that they should only make their investments based on the most recent Prospectus which contains information about fees, expenses and risks, which is available from all distributors and paying/facilities agents, it should be read carefully. This is a marketing communication. Please refer to the prospectus of the UCITS and to the KIID before making any final investment decisions. The rate of return may vary and the principal value of an investment will fluctuate due to market and foreign exchange movements. Shares, if redeemed, may be worth more or less than their original cost. This is not a solicitation for the sale of shares and nothing herein is intended to amount to investment advice. Henderson Management SA may decide to terminate the marketing arrangements of this Collective Investment Scheme in accordance with the appropriate regulation.
    Specific risks
  • An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall. High yielding (non-investment grade) bonds are more speculative and more sensitive to adverse changes in market conditions.
  • When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise. This risk is generally greater the longer the maturity of a bond investment.
  • Callable debt securities, such as some asset-backed or mortgage-backed securities (ABS/MBS), give issuers the right to repay capital before the maturity date or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the fund may be impacted.
  • Emerging markets expose the Fund to higher volatility and greater risk of loss than developed markets; they are susceptible to adverse political and economic events, and may be less well regulated with less robust custody and settlement procedures.
  • The Fund may use derivatives towards the aim of achieving its investment objective. This can result in 'leverage', which can magnify an investment outcome and gains or losses to the Fund may be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
  • If the Fund holds assets in currencies other than the base currency of the Fund or you invest in a share/unit class of a different currency to the Fund (unless 'hedged'), the value of your investment may be impacted by changes in exchange rates.
  • When the Fund, or a hedged share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency, the hedging strategy itself may create a positive or negative impact to the value of the Fund due to differences in short-term interest rates between the currencies.
  • Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
  • The Fund involves a high level of buying and selling activity and as such will incur a higher level of transaction costs than a fund that trades less frequently. These transaction costs are in addition to the Fund's Ongoing Charges.
  • Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
  • The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
  • In addition to income, this share class may distribute realised and unrealised capital gains and original capital invested. Fees, charges and expenses are also deducted from capital. Both factors may result in capital erosion and reduced potential for capital growth. Investors should also note that distributions of this nature may be treated (and taxable) as income depending on local tax legislation.
  • The Fund invests in Asset-Backed Securities (ABS) and other forms of securitised investments, which may be subject to greater credit/default, liquidity, interest rate and prepayment and extension risks, compared to other investments such as government or corporate issued bonds and this may negatively impact the realised return on investment in the securities.