The Fed plans to stay dovish. Do markets believe it yet?
The Fed lost control of its communication strategy after its June meeting, which was interpreted as surprisingly hawkish. Fortunately, some of the market moves that followed that meeting have receded. The Fed will need to sound a more consistently dovish tone – and be proven right about inflation being transitory – to fully regain its credibility.
Back on track after a rocky month
The July meeting of the U.S. Federal Reserve’s Open Market Committee (FOMC) was a chance for policymakers to right the ship after wavering at the last meeting in June. Official forecasts from that meeting showed that a growing number of committee members are willing to tighten policy (through higher interest rates) earlier and faster in response to the recent rise in inflation. As a result, the Treasury yield curve flattened, with markets expecting higher rates in the near term, but lower rates beyond that.
The flatter yield curve is a sign that the bond market believes the Fed may commit a policy error by tightening too soon or too quickly. Investors might recall a similar situation in late 2018 and early 2019 when the Fed quickly spun from hiking to cutting rates in the face of wavering markets and slowing growth.
There was no such dramatic reversal at today’s meeting, but without new forecasts to muddy the waters, Fed Chair Jerome Powell was able to seize the megaphone back in his press conference and confidently reassert his intention to stay patient in the face of the resurgence of COVID-19 in the form of the Delta variant.
The Fed’s statement acknowledged the improving economy, saying that there had been “progress” toward its economic goals but, apparently, not yet the “substantial further progress” required to reduce its asset purchase program. A clause from the previous statement regarding falling COVID-19 cases was omitted, an implicit nod to the spread of the Delta variant over the past month.
Inflation risks = growth risks
The reason anyone is even discussing tighter monetary policy barely one year removed from a deep recession is that inflation data continue to surprise us with its strength and persistence. The U.S. consumer price index has risen 5.4% over the past 12 months, driven primarily by higher energy costs and acute shortages in goods-producing industries in the face of strong consumer demand. The Fed’s preferred inflation gauge, the core personal consumption expenditures (PCE) index, rose 3.4% in the 12 months ending in May. We’ll likely learn that it accelerated further when the June figures are released on Friday.
But wait! Why have long-term interest rates fallen with inflation running as hot as it has it in decades? The U.S. 10-year Treasury yield has reversed all of its climb from mid-February to its 1.74% apex on March 31. Paradoxically, that’s right around the time when higher inflation data began to roll in. Even breakeven rates of inflation implied by Treasury Inflation Protected Securities (TIPS) are down significantly from their peaks in mid-May.
There’s only one explanation for why higher inflation has flattened the yield curve: The bond market is more worried about the Fed’s reaction to inflation than it is about inflation itself. Instead of rising in the face of surging economic growth and shortages of goods and workers, inflation expectations have actually dropped on fears that the Fed will step in too soon to cool things off and cause a recession. Inflation risks have become synonymous with growth risks, because markets view inflation through the prism of monetary policy.
The June FOMC meeting and its “dot plot” confirmed some of these fears, resulting in a sharp rise in market-based forecasts for Fed rate hikes in 2022 and beyond. But leading up to the July meeting, most of these moves have reversed as both the COVID-19 Delta variant and signs of a clear peak in U.S. and global economic growth have become more common. The Fed now has a second chance to convince us it intends to move slowly and only when its criteria for hiking rates – full employment and expectations that inflation will durably exceed its 2% target – have been met. It seems to have sold investors on the current inflation bump being temporary. Now the Fed only needs to convince them that it will remain accommodative until unemployment falls to very low levels and wage inflation becomes a more pressing risk.
QE taper to begin in Q1 2022
Unlike the end of zero interest rate policy, the end of quantitative easing (QE) will soon be here. This policy of bond-buying was originally intended to provide emergency liquidity last year, but is now being done to keep financial conditions loose. This program is probably about to outlive its usefulness, if it hasn’t already. The $40 billion of monthly mortgage-backed securities purchases, in particular, is being criticized by economists and market observers for overstimulating an already hot U.S. housing market.
The good news is that unlike 2013 – the year of the so-called “taper tantrum” – this second QE wind down is unlikely to cause much of a stir, precisely because it has been so well telegraphed. We expect the Fed to announce in either November or December that it will begin trimming monthly purchase amounts in the first quarter of 2022. Those purchases should taper down to zero by the end of next year. Rate hikes will probably wait until late in 2023, unless it becomes clear that labor force participation has been structurally diminished by the events of the past 18 months.
What is a fixed income investor to do?
The drop in interest rates on most bonds since March has not made life easier for fixed income investors. Long-term rates have fallen as credit spreads have compressed, raising valuations across markets. The prospect for cash looks no better, though, especially if we’re right that the Fed will wait at least another two years to hike rates.
Our Global Investment Committee’s midyear outlook listed B-rated corporate bonds and loans, as well as preferred securities, among its best ideas in taxable fixed income markets for the balance of 2021. Within the municipal market, we favor issues in sectors like airports and convention centers that are tied to ongoing economic reopenings. We also see an opportunity in lower-rated bonds that are getting a boost from the March stimulus package and could receive another from one or both of the infrastructure bills currently being debated in Congress.
Federal Reserve Statement, July 2021.
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A word on risk
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