The spaceship is seemingly veering off course and the loss of control is spooking investors. Here are some telltale signs. Rampant inflation – highest in four decades. Sharp back-up in bond yields with the two-year tenor rising the most since 1982. Super-sized 75 bps Fed rate hike – biggest since 1994. Policy credibility on the line. Rising fears of stagflation or recession.
How did we get here?
The latest data showed the Consumer Price Index rose by an above consensus 8.6% in the 12 months to May, the highest since 1982. Core inflation remains elevated at 6%. Overall, inflation is also more broad-based with rising momentum across sub-categories. Not only did this data release dash hopes that inflation may be peaking, but the red-hot pace of food, energy and shelter prices is worrisome.
The Fed’s task to rein in runaway inflation keeps getting harder, as does its effort to restore its credibility. Self-admittedly behind the curve, the Fed now finds itself fighting price pressures that have proven to be anything but transitory – inflation has been persistent and pervasive and is being driven by exogenous factors that cannot be directly tamed by monetary tightening. The longer inflation remains elevated, the more entrenched long-term inflationary expectations, already at their highest since 2008, will become.
Higher food and fuel prices and rising shelter costs are now directly impacting households. Companies have already signaled that they have no choice but to pass on higher input and labor costs to consumers. And even though wages remain buoyant for now, inflation is eroding spending power. All this serves to reduce household real disposable incomes and is weighing on consumer sentiment. Meanwhile, supply-side constraints persist amid China’s Covid woes and the Ukraine conflict.
Given these inflation drivers, conventional monetary policy tools are blunt and ineffective. Therefore, the Fed has no choice but to put in place a fast and furious rate hike trajectory that will result in curbing demand and drastically slowing down economic activity.
Indeed, the Fed’s hand was forced at the June 15th FOMC meeting. Alarmed by the latest CPI and PPI prints, policymakers had no choice but to raise the benchmark federal-funds rate by 75 bps to a range between 1.5% and 1.75%.
Against this backdrop, there are three important questions at the forefront of investors’ minds.
First, what is the likely terminal rate of the ongoing tightening cycle? Latest projections show officials now see the fed-funds rate peaking at about 3.75% by end-2023 which is the median forecast of FOMC participants – this is a 100 bps increase from official projections just three months ago. Five FOMC participants saw a rate peak above 4% and as high as 4.375% by the end of next year. The market is pricing in a peak fed-funds rate of 4% by as soon as May next year. Clearly, we are still in the early stages of what will surely be a long and arduous rate hiking cycle. A lot more tightening needs to be delivered via both rate increases and the onset of bond sales as part of the long overdue quantitative tightening (“QT”).
Second, is the Fed willing to relent on its price target of 2%? In other words, in order not to tip the economy into recession, would the Fed be willing to stop tightening policy when inflation subsides to only around 3%, for example? For now, Fed Chairman Powell’s answer to this question is an emphatic no – as he put it, the Fed is “absolutely determined” to keep inflation expectations anchored to 2%. He may yet have to walk these words back at least partially in the coming months as the market proxies for inflation expectations, the US breakeven five-year and ten-year rates to be precise, continue to hover around 3% and 2.7% respectively.
Third, what is the Fed’s tolerance for recessionary risks? This question is especially important given that the sharply steeper rate hike path and higher terminal rate that the Fed has been forced to embrace have shortened, if not eliminated, the runway for an economic soft landing. Mr. Powell admitted to the complexity of walking the tightrope between not triggering an economic downturn and trying to tighten policy aggressively, by saying “It is not going to be easy”. Even so, he has made it abundantly clear that the Fed’s overarching goal and commitment is to bring inflation back down, thus implicitly acknowledging that the potential costs of recession and/or higher unemployment will be paid if need be. Indeed, re-inverted yield curves (5-30 yr and 3-10 yr are already inverted while the 2-10 yr is close to inverting) in recent weeks are reflecting renewed apprehensions of recession and an economic hard landing.
Looking ahead, it is clear that investors need to keep their seat belts firmly tightened as there is greater urgency for the Fed to act decisively. Risk assets have sold off and there could be more downside. Not only are bigger dollops of rate hikes likely to be delivered in the next several FOMC meetings, but the terminal rate may also need to be higher to effectively tame rampant price pressures. The pace of quantitative tightening, which has just begun, may also have to be quickened. This does not bode well for Treasuries and mortgage securities as the Fed’s balance sheet begins to shrink in earnest in the coming months and years.
Yet, there is an expanded opportunity set for seasoned relative value managers across rates, mortgages and credit. For example, along with MBS yields, the 30-year fixed mortgage rate spiked by as much as 60 bps in the two days since the May CPI report. Mortgage spreads have moved to their widest in over two years as mortgages severely underperformed their Treasury hedges. Even as the mortgage basis is being crushed, there may be tactical opportunities in this sector as MBS origination is being relatively well absorbed, supply is likely to remain light and sharply wider spreads look appealing on a relative value scale.
Overall, however, the spaceship is likely to remain wobbly for now. There is a high probability that the inflation specter continues to loom on markets sentiment due to exogenous factors. Therefore, it is likely that we have not yet seen the end of the worst US bond market sell-off in about half a century. A freshly resolute Fed is going to have to stay the course with its double-barreled salvos of aggressive rate hikes and QT. We expect heightened volatility across asset classes to remain in place as the Fed navigates uncharted territory. In such an environment of policy uncertainty and investor pessimism, tightening financial conditions via rapid rate hikes and ongoing QT will further ramp up pressure on both equity and fixed income markets and other risk assets in general.