Biggest hike in two decades
The Fed tightened rates last night by 50bps, as anticipated. Further hikes are expected throughout the remainder of the year.
Recession or soft landing?
Our economist is seeing a recessionary indicator in the data. Can the Fed cool things down without creating a recession?
Gradually adding duration risk
Will bond market volatility play into the hands of active investors? We’re gradually adding duration risk, but remain at low levels.
Last night, the US Federal Reserve tightened rates by 50bps.1
It was the first 50bps rate hike since 2000, and the first time the Fed has raised rates at back-to-back meetings since 2006.
Fed Chair Powell paved the way for further activism when he stated that 50bps hikes were likely ‘for the next couple of meetings’.
The US central bank also provided detail on how it would begin to shrink the size of its now very substantial $9 trillion balance sheet following years of bond purchases.
The process will begin next month, and increase to a monthly run-off rate of $60 billion for US Treasuries and $35 billion for mortgage-backed securities.1
Two-year US government bond yields actually rallied 14bps on these announcements.2
This goes some way to showing what the market has been expecting for US rates in recent months.
Let’s put this hiking cycle into context
So far this year, we’ve had +75bps.
Assume further 50bps hikes at the next two Fed meetings, then 25bps for the remaining three Fed meetings of the year.
That gets you to 2.5% of tightening – the most in a year since 1994.
However, if we add another 25bps for the reduction of the Fed’s balance sheet, then it will represent the most aggressive Fed tightening in a calendar year since 1978.3
With the US economy running hot and inflationary pressures abounding, investors understand that it will be a tall order to cool things down without creating a recession.
Indeed, our economist has remarked on a telling pattern in the US.
On almost every occasion that the Consumer Price Index (CPI) has been higher than the rate of unemployment, a recession has followed within two years.
Today, US CPI is the highest it’s been in decades, while the unemployment rate is very near its lowest point.
Energy and food prices: a known unknown
A known unknown is the impact of higher energy and food prices.
In the short run, this should dampen demand and help cool the economy somewhat.
However, if the labour market is strong enough to counteract the loss of real incomes by forcing through big wage increases, then the ultimate peak in interest rates will have to be quite a bit higher than the market is expecting today.
What we see in the US labour market is record job openings relative to unemployment, and wage growth of between 5% and 6.5%.
The omens are there.
How to react as a bond investor?
Clearly, we are in bear market territory.
US Treasury returns this year are already -8.5%, outstripping the losses of the post-Covid recovery, the 2016 sell off and the Taper Tantrum of 2013.4
Other government bond markets are showing similar declines.
For us, it’s bittersweet.
On the one hand, no fund manager likes to see their funds posting losses. On the other hand, this might just be the beginnings of a big investment opportunity.
For years, we have been defensive in duration.
Our argument was that ultra-low returns did not compensate for the risk that, one day, yields might move higher and leave investors nursing losses.
Until now, our view has been like the dog that didn’t bark.
But with inflation back with a vengeance and the Fed applying the brakes as quickly as it dares, bond markets are more volatile than they have been in a long time.
If managed well, this backdrop might just play to the strengths of active management. We are gradually adding duration risk across our funds but remain at low levels.
1Source: 4 May FOMC press conference [https://www.federalreserve.gov/newsevents.htm]. Accessed 5 May 2022.
4Source: ICE and Bloomberg.
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