Portfolio Manager Jason England believes that the US Federal Reserve (Fed) will continue down a data-driven, methodical path as it first initiates interest rate increases and then possibly utilises its balance sheet to influence longer-dated interest rates.
- As expected, the Federal Reserve (Fed) telegraphed that it would raise interest rates in March but was noncommittal on how it would approach balance sheet reduction from crisis-era levels.
- We believe that persistent inflation will lead to enough rate hikes in 2022 to flatten the Treasuries yield curve and that interest rate risk should be at the forefront of investors’ minds.
- We also think the Fed may be more assertive in utilising its balance sheet than it was post Global Financial Crisis to control the level of longer-dated yields.
In one of the more anticipated US Federal Reserve (Fed) meetings in recent memory and that did not feature an update to its Summary of Economic Projections, Chairman Jerome Powell offered few surprises. In a unanimous decision, Fed officials left interest rates unchanged but did offer insight into its next steps as it guides monetary policy away from a regime of extraordinary accommodation.
Citing a level of inflation well above the Fed’s longer-term target of 2.0% and a historically tight labour market, Chairman Powell indicated that an initial rate hike would occur at its March meeting. Yet, concerns about rising prices were not enough to cajole the Fed to pull forward the completion of its balance sheet tapering, preferring for it to continue on schedule into early March.
TIPS market-based inflation expectations
While off their late-2021 highs, market-based inflation expectations still sit well above the Fed’s 2.0% longer-term inflation target, further solidifying the case for the Fed to raise rates.
Source: Bloomberg, as of 26 January 2022. Breakeven inflation is the inflation rate derived from nominal Treasury yield and yield on Treasury Inflation Protected Securities.
While many observers have been calling for an immediate 50 basis point (bps) hike, we don’t think that fits Chairman Powell’s modus operandi. In our view, he continues to act with deliberation, allowing the data to dictate future actions and communicating the Fed’s intentions well in advance of any policy changes. A case in point were the guiding principles he discussed when approaching future policy. Of note was an emphasis that interest rates will continue to be the primary tool to adjust policy and that only secondarily would adjustments to its balance sheet be considered.
Deploying a blunt tool
Even with its historical bias toward dovishness, the Powell Fed has come to recognise that the time to raise interest rates is fast approaching. The fed funds target rate, however, is a notoriously blunt instrument that, when raised aggressively, can constrict economic growth and even lead to recession. This is an outcome the Fed seeks to avoid given continued uncertainty about the future path of the US economy. And by not committing to a specific number of hikes or changes to its balance sheet, the Fed is positioning itself to maintain a level of nimbleness to confront any unforeseen developments that could occur over the near- to mid-term horizon.
Our view is that they will lead with a single 25 bps in March, likely followed by two other 25 bps increases over the remainder of the year. Given the lag it takes for higher rates to flow through the economy, we would not be surprised if the Fed sticks to the quarterly meetings to observe the impact of its initial moves. Still, with inflation having already stung the Fed once, we believe that should its call on moderating prices fail to materialise, rate hikes could potentially be on the table in any meeting this year.
A yield curve in motion
The expectation of higher policy rates has already exerted upward pressure on the front end of the Treasuries yield curve. We expect that to continue. The associated higher cost of capital would likely tamp down on future economic growth (and inflation) expectations, relieving some of the upward pressure recently felt on longer-dated Treasury yields. Accordingly, we can foresee a flattening of the yield curve as rate hikes commence.
US Treasuries yield curve has flattened as market prepped for rate hikes
Higher policy rates often lead to flatter yield curves as investors factor in the knock-on effects of higher policy rates on economic growth.
Source: Bloomberg, as of 26 January 2022.
While some flattening should be expected at this stage of the cycle, the Fed would not want the situation to get out of hand. Should stickier-than-expected inflation lead to the market’s estimate on 2022 rate hikes being more on target (they’ve recently risen from 4 to 4.5, while the Fed projects only 3), the yield curve could flatten too much and even invert. That is considered an indicator of impending recession and the Fed would undoubtedly want to take steps to guide the market away from that conclusion. Another reason for the Fed to prefer a steeper yield curve is the presence of a term premium incentivising the risk-taking that rewards capital for investing in the longer-duration investments that drive durable economic growth.
Past is prologue – again
More so than with shorter-dated maturities that tend to be tethered to policy rates, the market gets a vote on the level of longer-dated yields. Yet this time around, owing to the gargantuan size of its balance sheet, the Fed may have an additional tool in influencing these yields. Should the curve come close to inverting, the Fed could adjust how it rolls off assets and even – should conditions merit – sell some securities.
We believe that even though the Fed downplayed the role of balance sheet reduction, conditions could unfold in a manner that would favour this scenario: a couple of rate hikes, a pause and if the curve flattens too much, the balance sheet could be deployed to put upward pressure on longer-dated bonds. Should the Fed choose to take this course, we could envision the yield curve first flattening, then steepening later in the year.
This is largely theoretically as the Mr. Powell said precious little about the Fed's plan to roll down its balance sheet. This, too, was likely by design. We believe the Fed is following last year’s taper playbook, when they first weren’t “talking about talking about it,” then “talked about it” and ultimately came up with a framework they telegraphed to the market. Consequently, we believe the market will receive considerably more guidance on balance sheet reduction in coming meetings.
With inflation still present, and not just in the US but globally, we believe that interest rate volatility will continue and that exposure to interest rate risk (duration), should be approached by investors with caution over the near term.