By Jason England, Global Bonds Portfolio Manager at Janus Henderson Investors
If Wednesday’s announcement by the Federal Reserve (Fed) proved anything, it is that the U.S. central bank continues to prioritize forward guidance in signalling the future path of monetary policy to reassure financial markets that its hands remain firmly on the tiller during a period of considerable economic uncertainty. After its botched call on transitory inflation, Chairman Jerome Powell and company have their work cut out for them.
As had been telegraphed, the Fed raised its benchmark policy rate by 50 basis points (bps) for the first time in over two decades. Not much else can create a sense of urgency than 8.5% year-over-year inflation. Despite this move, we still believe that the Fed – and other central banks – have yet to reach peak hawkishness. This current bout of inflation, in our view, has too many unpredictable sources to simply be placed back in the bottle by raising policy rates in a circumspect manner. Pandemic-related supply dislocations, a growing economy, accelerating deglobalization, the war in Ukraine and the historic amount of liquidity created out of thin air by the world’s central banks to cushion the blow of what turned out to be the short-lived recession have all contributed to the historic run up in prices across much of the global economy.
A Change of Pace, Not Destination
In his comments, Chairman Powell acknowledged as much and set the table for pulling forward even more of its normalization program. Among these are likely two more 50 bps rate hikes and the rapid ramping up of balance sheet reduction – ultimately topping out at $95 billion monthly – by not reinvesting maturing Treasury and mortgage securities. This is not to say that the Fed has changed its final destination. At its March meeting, after all, it actually lowered its expectation for the neutral policy rate from 2.5% to 2.375%. But given the lagging effect of monetary policy along with inflation at multi-decade highs, we believe the Fed has made the right call by pulling forward normalization and then closely monitoring data over the latter half of the year to watch how prices and economic growth evolve.
Evidence, thus far, is that the Fed’s about face over the past few months is finding receptive ears in financial markets. We see that, foremost, in a flattening yield curve. Over the course of 2022, the yield on the 2-year U.S. Treasury has risen 191 bps to 2.64% (after Wednesday’s fall in yields) as the market priced in near-term policy rate increases. Meanwhile, the yield on the 10-year has climbed by less dramatic 141 bps, to 2.92%. We interpret this as the market seeing the Fed having a fighting chance in piloting the U.S. economy toward a soft landing. If the Fed had lost all credibility with investors, we’d likely be seeing a spread between 10-year and 2-year Treasury yields at a level higher than the current 28 bps. Other market-based data send the same message. Inflation expectations based on Treasury Inflation Protection Securities (TIPS) have fallen from 3.73% in late March to 3.24%. Over a 10-year horizon, TIPS imply a 2.88% annual average, again, off its recent peak. Of note: both rose slightly post the Fed announcement.
Interpreting from a Fixed Income Lens
The flattening yield curve has changed the landscape for bond investors. While higher yields on shorter-dated maturities may be a welcome development for those who have long awaited the chance to generate higher returns on more liquid instruments, the absence of what we consider an appropriate term premium on longer-dated Treasuries reduces the allure of these securities at present. This is especially true given the current elevated level of inflation whose ingredients include sources that may not be responsive to higher policy rates.
Like the Fed, we’ll be closely watching for signs of inflationary pressure subsiding over the next several months. This will likely take time and much depends upon supply disruptions and labor shortages being resolved. It remains our view that the market has likely been too aggressive in estimating the number of rate increases the Fed will implement over the next year. This is the Powell Fed, after all, with a history of erring on the side of dovishness. But with inflation at multi-decade highs, dovishness has become a relative term. Given the tight labor market, the Fed has the latitude to prioritize taming painful levels of inflation for American households. And until that’s achieved, any bias toward maintaining growth will likely take a back seat.
Futures markets presently see roughly the equivalent of eight additional hikes in 2022. In the immediate wake of Chairman Powell’s hint that an even more hawkish 75 bps increase is likely off the table, the Treasuries rout already lost some steam as the 2-year yield fell by as much as 25 bps on Wednesday afternoon. A more methodical path to policy neutrality, in our view, will likely lead to lower volatility on the front end of the yield curve than what investors can expect with longer-dated maturities.
And in keeping with recent tradition, all investors should stay tuned to additional forward guidance to glean how the Fed, itself, is assessing the trajectory of inflation and other risks to the economic recovery.