With the continuing strong inflation readings we are seeing in the US, we are suddenly faced with the very real prospect of a higher inflationary environment than fixed income traders and investors have seen in decades. Federal Reserve Chairman, Jerome Powell, has effectively stared into the whites of inflation’s eyes – and blinked. His recent remarks indicate that we have moved from the theoretical to the actual. Inflation is no longer “transitory” but real, and the Fed intends to do what it can in its power to try to manage it.
While there may be some politics at play in terms of the timing of Chairman Powell’s recent remarks (he waited until he was renominated to his post before making these comments), we expect that at the Fed’s next meeting on December 15 they will announce an acceleration of the taper starting in January, moving from a taper of $15b per month to $30b per month. This way the Fed will complete the tapering by March 2022, and therefore will have the flexibility to tighten rates a full 3 months earlier than previously anticipated. (Remember, The Fed has formerly telegraphed that they would not begin a series of rate hikes until they had completed the taper). The market is in the process of repricing the pace of the taper in anticipation of higher rates, and this will likely have a big knock-on effect in mortgage-backed securities, TIPS, and nominal Treasuries. The Fed is the largest player in the MBS space and their perceived taper from that activity will have a lasting impact on the market. Similarly, the TIPS buyback operations are a large percentage of TIPS issuance and greatly affect this market. Lastly, with the Fed out of the nominal treasury buying game, volatility and mispricings should increase along the US Treasury curve.
What structural factors are driving inflation?
Much of it is coming from the laws of supply and demand. While there are certainly still “bottlenecks” from Covid (China’s continual policy of “Zero Covid” tolerances which cause massive city-wide lockdowns and work stoppages), there are structural challenges underpinning the global supply chain crisis that are driving costs up and they are largely independent of COVID. In fact, while in some sense, COVID may have been the proximate cause of a greater recognition of the limitations of the global supply chain, highlighting the need for better local infrastructure and access to resources, in our view, COVID appears to be less of a longer-term factor at this point unless Omicron or some other variant evolves that causes 2020 style global lockdowns.
The more fundamental challenges to globalization include a re-emergence of more nationalist sentiments and a swinging of the pendulum back in the direction of the non-globalization of the supply chain. We believe the net effect of the non-globalization currents is inflationary, as it is not as efficient to have to control the entire supply/production chain in the creation of goods.
From a market perspective, the currents driving greater market volatility, which I have pointed to in my previous commentary over the past several months, are accelerating. The MOVE Index (a measurement of bond market volatility), has now reached a post-COVID high of 89, doubling from lows seen relatively recently at the beginning of this year. Factors such as the continued uncertainty around COVID and new variants, the continued acceleration of inflation past “transitory” levels, and the jobs market continuing to expand with rapidly falling unemployment rates are driving volatility on the front-end of the curve. We’re seeing that volatility has spiked dramatically in short treasury equivalents in Australia, the UK, and Canada while implied volatility in two-year US Treasuries has quadrupled since September.
All these factors coincide with the usual year-end timing issues where banks, asset managers, and hedge funds are reducing their balance sheets and tolerance for risk to help support year-end performance numbers. The net effect is to diminish liquidity and the tolerance to take risk.
For fixed-income strategies (including fixed income multi-strategies), the road ahead will continue to be rocky for many market participants. As I surmised in my last commentary in October, many fixed income multi-strategy managers found themselves caught offsides by the spike in volatility, hurting their October performance. November performance numbers will likely fare slightly better, but we’ve seen many hedge funds and fixed income desks experience large drawdowns over this period.
Thus, as we believe banks and other asset managers will cut back risk at year-end, the opportunity set is encouraging for those that have properly managed for the dramatic rise in volatility that we expect to continue. As a general statement, Mariner is proud of our ability to have successfully navigated these factors thus far, and as other managers pare back their risk, we will look to increase our risk exposure and ride the volatility waves into 2022.