We’ve seen a significant shift in short term Federal Reserve (Fed) policy in the last month, beginning with the publication of the Fed minutes on 5 January, much of which Chair Powell appeared to double down on in the January meeting press conference.
With inflation now a hot and perhaps divisive topic in Washington, the Fed is now determined to bring down inflation at almost any cost: there is now priced a 100% chance of at least a 25bps policy hike in March, and the Fed has brought into play the possibility of a hike at every monthly meeting through the spring and summer.
It’s worth remembering that in the last tightening cycle six years ago, the Fed moved once a quarter. We now see five rate hikes priced into market in the next twelve months, and a few more in 2023. The Fed isn’t bothered by recent market movements and for the time being at least would appear to view volatility in equity and credit as a reasonable correction – and to be fair credit markets have so far been relatively resilient. In our view the Fed is overreacting to inflation that will remain largely transitory, and to political pressure ahead of November’s midterms – see Joe Biden’s “hot-mic” comments1 (that can’t be reprinted here) to a journalist that revealed how much inflation is a political issue for the Democrats.
We continue to think inflation is transitory and will subside as supply chain bottlenecks ease and people return to work, and therefore both the Fed and markets are overreacting. Inflation will start to ease – we continue to see early signs in PMI data and inventory data – and that will give the Fed more breathing space as we head into the back end of 2022. The question is how much damage will be done by faster tightening of policy before the Fed changes course?
The volatility we are seeing in markets is, of course, in part a reaction to reduced liquidity, but it’s also showing that markets continue to suspect the Fed is making a policy error: flatter yield curves show the market is pricing higher short term rates at the expense of longer term growth, choked by tighter policy.
We have a strong conviction that the number of rate hikes currently being priced won’t be realised. We’d also point to the relative flatness of yield curves: back in December 2015, the spread between US 5-years and US 30-years was 1.3% (i.e. the US 30-year yield was 1.3% higher than the US 5-year yield). That spread fell to almost nothing over the next two and a half years before the Fed had to slow the pace of tightening. Today, that same spread is just 0.5%, having fallen from 1.5% at its peak in Q1 last year, driven by expectations of tighter policy. There is now much less room for the Fed to keep tightening before the yield curve inverts and it again has to change course.
The other key part of our analysis is that the market is looking at reasonable short term fundamental data, particularly with regard to company earnings which can continue to look good for a while as the world reopens, but underestimating how quickly both inflation and growth will slow later this year. A combination of durables spending exhaustion (leading to goods deflation later in the year), material Q4 inventory rebuild, the negative effects of short term inflation on consumer confidence, much less fiscal stimulus than we saw in 2020 or 2021, US political gridlock, significantly higher cost of energy and a structural change in Chinese economic policy, will in our view reduce growth, and that will become increasingly apparent later this year.
Furthermore, over the last twelve months we have seen nearly 100 rate hikes globally, primarily for emerging markets. The impact of these hikes will start to filter through and also act as a drag on growth sooner or later. We also continue to point to the long-term factors of weak demographics and excessive debt as permanent constraints on growth and inflation.
When you combine these factors with the Fed’s determination to tighten policy quickly, our expectation remains that volatility in risk assets continues, growth and inflation come down, and the Fed is able (or forced) to slow the pace of tightening later this year, leading to lower rates and a supportive environment for high yield.
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