In this edition of Macro Monitor, we lay out our current strategy framework and highlight the key risks to our views. We do see bond prices falling for the most part in 2022, but we believe a flexible strategy like ours can capture moves to the short side where they occur. We also talk through the position hedges that can be used to lower exposure should risks to the view materialise.
The inflation dynamic has changed over the last four months, and that has been recognised by the financial markets and the central banks. The focus had been on transitory inflation, which is heavily related to supply-chain problems that resulted from the economic rebound from Covid-19 pandemic lockdowns.
While the market was monitoring transitory inflation normal cyclical inflation started to pick up as output gaps closed. In the US, it is fairly extreme as wage inflation rises. It is a similar story in Europe though wage inflation has been less of an issue so far.
Data released in January showed US consumer price inflation rose by 7% in 2021, higher than economists expected, and the biggest 12-month increase in 39 years. Inflation has become a political problem for US President Biden, who is worried that voters might channel their frustrations about higher household expenditure into the mid-term Congressional elections in November. This in turn has forced the US Federal Reserve (Fed) to become more hawkish.
We think the transitory inflation, i.e. the supply bottlenecks, have started to ease. You can see that in manufacturing data and delivery times. This is positive but cyclical inflation is a little more problematic.
Higher prices impacting consumer sentiment
University of Michigan Consumers Survey on Buying Conditions for Large Household Durable Goods
Source: University of Michigan, Surveys of Consumers, December 2021
The reaction in financial markets to the Fed meeting in January – and the December meeting – was dramatic. The market has priced in at least five interest rate hikes by the Fed in 2022, which is perhaps getting to extreme levels. The view is that the recovery is strong, the omicron variant of Covid 19 appears to be fading, inflation is high and the politics around inflation are getting difficult.
What happened after the most recent Fed meeting was that the dollar strengthened, the yield curve flattened, and equity markets fell sharply. Since then, the Fed has backpedalled somewhat, saying that they don’t want to upset markets. Be warned however, this walk back is only if inflation allows it to be so.
Focus on tightening
What the Fed would likely prefer is a steep yield curve, a less strong dollar and most of all an elongated cycle. The Fed recognises that their recent hiking cycles were cut short in the past when they over-tightened and caused the dollar to rocket higher. All these instances ended with an embarrassing U-turn, market falls and the Fed having to add liquidity. Our view is that the Fed is going to use quantitative tightening (QT) to reduce the size of the bank’s balance sheet by slowing the purchase of bonds in a bigger way this time.
More than five hikes this year is absolutely possible, but not our base case. A key difference in this hiking cycle is the ECB is also tightening and so it should not be too upsetting for markets as real yields rise everywhere and the recovery is global in nature and with it the dollar should remain subdued.
Also, although the Fed say the main lever to control inflation is interest rates, we believe they are going to use a high level of QT, winding down bond reinvestments by about $100 billion a month. They hope this will allow them to go easier on policy rate hikes and slow the economy without sending the dollar rocketing. The Fed has also acted to prevent a liquidity shortage that has caused problems in the past. This time they have put together liquidity vehicles, including repo facilities and the FX swap facility. They are saying, `Yes, we will be buying fewer bonds under QT, but if anyone needs dollars, come to us.’ They have set this up so they are able to shrink their balance sheet more and hike less, in our view.
Short, sharp cycle of rate hikes?
We think five rate hikes this year is likely the ceiling. That said, more rate hikes will need to be priced in for the future. The market expects a short, sharp hiking cycle as global growth is weak, but we believe the opposite is in fact the case and that we are potentially entering a period of synchronised global growth. The implications of this could be profound, especially if the Fed are not alone in hiking interest rates. The chart below shows the US budget deficit vs the term premia (a measure of risk premium in government bonds). The relationship broke down when the ECB adopted negative interest rates in 2014 and forced rates down globally. If the ECB follow up on their commentary and start hiking, then government bond yields could reprice much higher:
US 10y Premia vs US Budget Deficit
Source: Bloomberg as at 3/2/2022
In a scenario of synchronised global growth, it makes sense to look toward non-dollar higher yielding global government bonds. There has already been substantial rate hikes in many of these emerging sovereigns that were unable to ignore rising global inflation in 2021 as much as the US did. Developed market sovereign bonds globally will remain under pressure and we position on the short side as rates rise and inflation fighting begins. Investment grade and high yield credit may struggle to make returns as liquidity is withdrawn and the low inflation ‘carry grab’ world ends. Inflation bonds offer less value as central banks finally kick into gear.
There are three main risks: that US inflation remains elevated, which would cause more near-term hikes. Geopolitics is another risk — if it causes investors run to the dollar for safety. China growth is another risk. It would be a mistake if China maintains its zero Covid policy – this could have reverberations on global growth.
At the time of writing, we don’t see a policy mistake happening. We think the central banks can get on top of inflation without excessive rate hikes. This will allow the yield curve to stop inverting and the market can stop predicting doom. The dollar can remain tame and not hinder global growth or asset markets. It is possible this time to have a synchronised recovery and globally rising yields.
What could really hurt risk markets
The main risk for risky asset markets is that real rates across all markets are too low if the central banks want to properly address the inflation issue. US real rates have risen over the last few months as bond markets have repriced yields higher and inflation has for the most part traded sideways as the chart below shows:
US real rates still negative
Source: Bloomberg, as at 3/2/22
However, US real rates are still below their pre-pandemic level, and also still significantly negative at -0.70%! If the Fed is serious about addressing the inflation problem, then negative real rates don’t seem to be at the appropriate level. Interestingly when the Fed was trying to normalise rates back in 2018, when core US inflation reached 2.4% relative to the current 5.5%, the Fed moved real rates to 1.0%. It is easy to forget that this is not just a US story but a global one. Indeed, Spanish producer prices are rising at 35.9% a year.
This is the core of our current view, that real rates across the curve need to rise and probably materially. The risk around this view is if US real rates have to be forced up aggressively as inflation remains too high. This would threaten the cycle and may create a nasty repricing lower of equity and credit markets which would halt the bond sell off and invert the curve. However, this is not something we think will happen as we believe the growth backdrop is still positive globally, but to hedge this risk we would own very little corporate bond securities and would enter some credit derivatives that would benefit as credit spreads widen.
Model portfolio holdings / asset allocation are not a recommendation to buy or sell. The model portfolio shown is for indicative purposes only and does not relate to any Jupiter products. Source: Jupiter, 08/02/2022
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