It’s easy to get carried away by headline numbers. The biggest jump in US consumer prices inflation since 1981 has piled pressure on the Federal Reserve to hike rates aggressively. The markets are pricing in ten 25 basis points interest rate increases this year alone, after the Fed kicked off its rate hiking cycle in March. As we approach the mid-term elections, the political pressure on the Fed to smash inflation can only grow. This all adds up to the hardest period for fixed income investors since the 1980s (happily, selloffs like this are rare). The question right now is: when is the time to lock in these higher yields? We think it’s soon.
Various factors at play already point to an economic slowdown. Governments and central banks are committed to withdrawing the extraordinary support that they provided to protect growth at the height of the pandemic, while China has stuck to its strict zero-Covid policy. The strength of the US dollar, which is at the highest level in more than 19 years due to its haven appeal, has a big tightening effect on financial conditions. The Russia-Ukraine conflict has added another layer of uncertainty, pushing up oil, natural gas and commodity prices, including food. Similarly, these price spikes act as a tax on the consumer and, ultimately, have a deleterious effect on demand.
Equity markets continue to slide, putting pressure on consumer balance sheets. While wages are rising in the US, they’re being outpaced by inflation. Real average hourly earnings have declined for 12 straight months. The spike in short-term Treasury yields has pushed mortgage rates higher and new mortgage applications are slowing fast. The spending squeeze is real. Companies will see slowing consumption hit their top lines at a time when inflation is driving input costs higher.
As a result, earnings seasons over the balance of the year could produce some sizeable surprises to the downside. Put simply, the global economy has limited capacity to tolerate higher interest rates.
For evidence of what the future may hold, look no further than the Treasury yield curve. The yield on the 2-year Treasury was slightly more than the 10-year for a short period in early April. The story was the same with 5-year and 30-year bonds. While short-term bond yields capture the likelihood of more rate increases, longer-term bonds indicate the prospects for growth and inflation.
Indeed, inflation has reached fever pitch. However, our view is that it’s likely to subside in the coming months as supply bottlenecks ease. Structural inflation will remain subdued as ageing populations means less spending on goods and services. Other aspects such as improved productivity due to use of technology, low-cost labour, too much debt and `zombification’ of the corporate sector will continue to keep inflation in check.
The way long-end Treasury yields are priced at the moment show that more tightening today means lower growth in the future. We expect the yield curve to continue to flatten and it won’t be long before it inverts across the piste. This has historically been a strong indicator that recession is near.
Exciting opportunities in fixed income
Extreme tightening by the Fed just when inflation begins to ebb and growth starts to slow points to high chances of a policy mistake. Every time the Fed has managed to engineer a soft landing in the past, it has tightened early and growth has been picking up. Today, the reverse is true. A hard landing seems inevitable. This is especially true when noting that the Fed’s mandate is to target lagging economic indicators with relatively blunt monetary policy tools that take time to have an impact. It should therefore be no surprise that historically they have often tightened too far, to the point where ‘something breaks’.
We don’t expect the Fed to reach anywhere close to the number of rate increases that are priced in the market right now. As we move through the rest of this year and into 2023, it will become painfully apparent that growth is slowing markedly, and central banks will be forced into a dovish pivot, slowing the pace of tightening.
Indications from the Fed that it may begin to reduce its massive bond holdings at a maximum pace of $95 billion a month, almost twice as fast as the peak trimming that happened between 2017 to 2019, will also dampen growth. The normal reaction function of the market is “buy the rumour, sell the facts.” It’s often true that investors typically react to news and tend to ignore the actual event. But in the case of quantitative tightening, markets have historically reacted when the Fed actually starts to taper, and we expect risk assets to suffer when the Fed begins to reduce liquidity. This will be a rude awakening for many investors who have been used to thinking that central banks are their friends.
This means that in portfolios, we continue to take a cautious stance with regard to credit risk: we’re keeping plenty of dry powder to be able to add risk as recession risk drives spreads wider. We’re excited about the upcoming opportunity set to lock in yields across fixed income at levels we have only seen from time to time in the last 15 years.
Shifting allocations: Asia focus
We have been reflecting on what sharp changes in geopolitics mean for our government bond exposure in Asia: we are concerned that reactions to the Russian invasion of Ukraine shows a world increasingly split into two camps. The aggressive sanctions of Russian assets provide a model for the future. Given we were already minded to take profits on our China government bond exposure, which has outperformed developed market rates this year, we have exited the position, given the tail risk of further instability for developed market investors.
We’ve replaced the majority of that China exposure in Korean government bonds. The Korean central bank has acted aggressively to contain inflation, and is likely to have to take a more dovish stance as a combination of the impact of higher rates on its giant property sector and the impact of China’s lockdowns slow the economy. Korea is also vulnerable to the same trends of weakening demographics and excessive leverage that have forced yields lower across developed markets, particularly Europe and Japan.
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