Too Hawkish Too Fast?
While the hawkish pivots last week may feel slightly abrupt to some, we still believe that there is a decent amount of flexibility built into the frameworks of central banks to be able to react to adverse economic outcomes.
The key theme from a flurry of developed market central bank activity last week was undoubtedly hawkishness, as policy makers fought to maintain their credibility in responding to rising inflationary risks.
While many aspects of the Federal Open Market Committee (FOMC) meeting were largely expected (taper acceleration, removal of transitory language regarding inflation), there were still enough hawkish elements that signaled that the Fed was willing and able to act should the committee deem inflation to be a risk, and arguably on the margin, the committee’s patience has been wearing thinner throughout the course of the year given the broader economic and labor market recovery.
Singing to the same tune as the Fed was the Bank of England, which surprised markets by increasing the bank rate to 0.25% despite the uncertainty presented by Omicron. Stronger than expected data on its labor market and inflation, as well as growing concerns about the knock-on effects of higher inflation on wage growth were cited as reasons for the hike.
While it is unlikely that the European Central Bank (ECB) lifts off in 2022 as medium-term inflation projections continue to remain below 2% beyond 2022 and the Euro Area continues to grapple with its growth challenges, the governing council still presented a plan to taper its pandemic emergency purchase program (PEPP) and public sector purchase program (PSPP) purchases to the 20bn EUR per month pace by October 2022, matching the pace of the regular asset purchase program (APP). They did try to soften the blow by announcing an increase in the APP to EUR40bn per month in 2Q 2022 followed by a gradual reduction of EUR10bn per month in 3Q 2022, and levelling off at EUR20bn per month from October onwards for as long as they deem necessary to reinforce the accommodative impact of its policy rates. However, this still veers hawkish as the APP purchases volumes are fixed and will eventually taper out. Expectations were for the ECB to maintain flexibility on APP purchases.
The Bank of Japan (BOJ) kept its policy rate unchanged during its latest meeting but also announced its intention to gradually lower its corporate debt holdings. Taking into account the economic challenges that have come with numerous waves of attempted reopening in fits and starts and the disproportionate impact on small and medium sized enterprises, the BOJ extended a special COVID-19 loans program by 6 months (ending September 2022) to continue supporting these firms.
All in all, although these central banks have unanimously acknowledged the near-term economic impact of Omicron (as evidenced by near term GDP growth numbers revised moderately lower), their policy focus seems to have marginally shifted towards taming the concerns surrounding the inflationary rhetoric.
EXHIBIT 1: FACTORS DRIVING THE DECLINE IN U.S. NOMINAL TREASURY YIELD BETWEEN 10 DECEMBER 2021 TO 17 DECEMBER 2021
Despite the broadly hawkish outcome at the FOMC, the week over week price action in U.S. 10-year rates left many perplexed. 10-year nominal rates fell by 8bps. Decomposing the move lower into a combination of term premium and policy rate expectations, it was surprising to see term premium driving almost all of the decline in the 10Y rate. Term premium represents everything else that affects interest rates other than expectations on Fed policy, and while there are structural reasons as to why the level is negative today, the cyclical force that drives its direction is an amalgamation of market participants’ views on the economic outlook. The move lower in the U.S. 10-year rate could be a reflection of how market participants are not as sanguine as the Fed in terms of their assessment and are perhaps more readily pricing in the uncertainty around the latest Omicron wave and its potential adverse impact on the economic recovery. This may explain the willingness to accept an even more negative compensation in exchange for holding a safe haven asset in an investment universe where there are not many options. The market could also be pricing in the possibility of a Fed policy error. If the conditions of maximum employment for a full Fed tightening cycle are not met, but the Fed goes ahead and hikes anyway, it may cause longer term scarring in the labor market, warranting the fall in longer term rates.
Another plausible explanation for the response was expectations; market participants expected the Fed to be even more hawkish going into the meeting but in the press conference, Chair Powell acknowledged that there was great uncertainty and continued to reiterate a strong willingness to be flexible and leverage the right tools to sustain the economic recovery, especially if things take a turn for the worse.
While the hawkish pivots last week may feel slightly abrupt to some, we still believe that there is a decent amount of flexibility built into the frameworks of central banks to be able to react to adverse economic outcomes. Eventually, the waning of the Omicron wave and the gradual recovery to a new normalcy should continue to support higher yields, steeper curves and risk asset returns. Amongst risk assets, there could be pockets of value within value vs. growth and cyclicals vs. defensive equities while credit valuations continue to look unattractive.