Was the market wrong? Is the Fed just guilty of a miscommunication or is a âredefinedâ framework now haunting investors? What if market participants panic just because their summer plans now include more uncertainty?
The main surprise was that the dot plot now involves two interest rate hikes before the end of 2023. More importantly, this indicates concerns within the Fed about the risks of upward inflation. This departs from his earlier characterization of inflation as transitory.
President Jay Powell has tried unsuccessfully to play down the dot plot and went on to say that there is “the possibility that inflation may turn out to be higher and more persistent than expected.”
Inflation: transitory or rising pressures?
We have believed for some time that the recent surge in consumer price inflation is due to base effects and supply bottlenecks as the US economy emerges from bottlenecks and demand resurgent encounter disrupted supply chains. However, cyclical and structural risks to inflation have also increased in the form of rising rents and wages. This created more persistent inflationary pressure in the background.
What does the dot plot say about inflation? Although there have been upward revisions to the 2021 inflation forecast, the 2022 and 2023 forecast has remained almost unchanged. To us, this looks oddly like a transient peak.
Source: Federal Reserve, BNPP AM; June 2021
The hawkish tone continued as President Powell shifted his way of talking about the pace of the economic recovery: he pointed out that the US labor market and the recovery had in fact strengthened and that the temporary constraints on the economy had become stronger. hiring would gradually decrease.
Although the Fed left the pace of quantitative easing unchanged, Powell alluded to the fact that talks about reducing billion-dollar asset purchases under QE had started, saying the phrase ” talk of talking about reduction “could now be withdrawn.
The market was both surprised and taken out of the game: 10-year breakeven inflation rate (BEI) fell from 2.41% to 2.21% (see appendix 2), the yield spread between 5- and 30-year US Treasury bonds flattened 140-107 bps and the benchmark 10-year US Treasury yield fell from 1.49% to 1.55%. This made investors fear that stimulus trading was dead.
These movements prompted us to immediately reconsider our long EIB positions and the steepening of the nominal curve.
All points are not equal
One interpretation of the market’s surprise is that this is simply a miscommunication on the part of the Fed, and President Powell does not control the dot charts and even tried to downplay their relevance as conditional forecasts.
Additionally, John Williams and Richard Clarida, members of the Federal Policy Committee, can point out that the important points always indicate that there is no rate hike (i.e. Powell, Williams and Clarida).
Powell’s post-FOMC testimony to Congress on June 22 provided an opportunity to calm the market and he conveyed a more conciliatory tone as he noted he was not concerned about an overheating economy. .
A misunderstanding of the inflation framework
Before the FOMC, the market may have assumed that the Fed was trying to compensate for past inflation understatements, but now the retrospective period and the start date of that period are in question.
Investors may have assumed that the Fed would generate a period of overshooting inflation – perhaps as high as 2.25% – by allowing the economy to “pick up” to “catch up” to years of underperformance. overrun of inflation after the Great Financial Crisis. This would involve a retrospective period that began long before the announcement of the new average inflation targeting framework DONE in August 2020.
Added to market frustrations, President Powell declined to clarify and specify a start date, saying “it’s discretionary, not a formula.”
However, when looking at Clarida’s “lite” version of the FACT (deferred rate take-off conditions followed by a flexible inertial Taylor rule), average inflation of 2% is defined as a target, but not a requirement.
What this tells us is that the Fed is not following the framework as aggressively as we thought it was. This is important because
- Rate hikes don’t even require inflation to be exceeded to start
- The Fed’s tolerances for inflation overruns are actually much shorter than the market perceives and any sign of inflationary pressure could lead to further tightening policies.
Excessive market reaction
It is also possible for the market to overreact, causing widespread panic and questioning of reflation trading.
There is a lot of position squaring going on and position erasing of BEI stiffeners and wideners. Large movements in the curve, breakevens and the USD all point to a relaxation in reflation trade.
Anticipation of investment implications
We now have a Fed that appears to care – rather than encourage – inflation overruns and rising inflation. In our opinion, the reduction in QE will start at the beginning of 2022. The signals will arrive first in September at Jackson Hole Symposium.
Our new schedule for rate hikes is set for early 2023. This is much earlier than expected. Due to the political uncertainty associated with a Fed that is less tolerant of higher inflation, the market will be hypersensitive to data on non-farm payrolls (NFP) and inflation, resulting in higher volatility in the near term.
From an investment perspective, we believe the new fair value of 10-year BEIs is around 2.35%. EIBs will now be determined by what happens with real inflation, so our focus shifts from the 10-year sector to the 5-year sector.
We continue to believe that real yields will rise, supported by the recovery and an accommodating fiscal environment, but not driven by EIB widening, and we will seek to strengthen our underweight to the duration of real yields.
On the yield curve, we maintain a nominal curve flattening bias, as lower inflation expectations, lower EIBs and lower inflation risk premiums will have a major impact on the rear of the curve. Therefore, we are reducing our nominal slopings, but are also aware that flattens involve negative carry and would seek to negotiate tactically around the release of NFP data.
Finally, lower breakevens and lower policy rates mean a lower target for the 10-year US Treasury yield. We have lowered our three-month target from 1.75% to 1.65%.
Prior to the June FOMC meeting, our strategy was positioned on a steepening of the US nominal yield curve, a long position in the US EIB index and a modest underweight to duration. Since the meeting we have:
- We reduced our exposure to real return by selling 5-year to 5-year forward real returns
- We reduced our nominal steepening of the yield curve
- Reduction of our long EIB position
We intend to further reduce our nominal steepening of the yield curve and our long positions in the EIB, and we will look for opportunities to increase our underweight to the duration of real yields.
All opinions expressed herein are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may have different opinions and make different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income from them may go down as well as up and investors may not get their original stake back. Past performance is no guarantee of future returns.
Investment in emerging markets, or in specialized or small sectors is likely to be subject to above average volatility due to a high degree of concentration, greater uncertainty as less information is available. available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, portfolio transaction, liquidation and custody services on behalf of funds invested in emerging markets may involve higher risk.