27 January 2022
The Fed vs inflation
‘Don’t fight the Fed’ has been a common mantra since the Global Financial Crisis. Following Fed Chair Powell’s January press conference, we analyse if the central bank can beat its next opponent, rampant inflation.
Fundamentals
The Federal Reserve (Fed) delivered a more hawkish message in its January press conference than the market anticipated. Inflation is high and the Fed will act. Chair Powell left open the possibility of faster and larger rate hikes, along with a reduction in the huge balance sheet it has accumulated through Covid. It appears that all options for tightening monetary policy are on the table. Rampant inflation is behind this dialling up of hawkish rhetoric, but the Fed will need the economy’s support in solving this issue. The labour market is strong and wages are increasing as the shortage of workers seems like it will persist. Supply chains are still disjointed, adding to inflationary pressures. It could be argued that the Fed is late in identifying its latest combatant, something which the market realised many months ago. The Financial Conditions Index, which incorporates equity moves, credit spreads, yield curves and dollar changes, is also showing signs of tightening from the ultra-loose financial conditions since the dawn of Covid. Corporate America, however, remains robust with low levels of leverage and strong earnings from early reporting companies.
Financial conditions have tightened, but not enough to spur the Fed off its hawkish path
Source: Bloomberg, J.P. Morgan Asset Management. Data as of 24 January 2021
Quantitative valuations
Following the Fed’s press conference, the market shifted to pricing in five 25 basis point (bps) rate hikes by the Fed in 2022 and expectations are for quantitative tightening (QT) to commence in the summer, which is likely to result in a flatter yield curve. The Fed’s lack of clarity on its position was not welcomed and does not provide reassurance to the market after the recent wobble in risk assets. US equities have fallen from highs and both investment grade and high yield credit spreads are at the widest levels since the Omicron variant was discovered, with a 5-year CDX spread of 60bps and 340bps respectively. Additionally the US 2s10s curve has flattened below 80 bps, which is the lowest level since 2020, providing a key recessionary indicator for the Fed to aim for the market to alleviate.
Technicals
Positioning according to our proprietary surveys suggests that the market is significantly short duration. This data is further confirmed by futures positioning. This is logical given the assumption of rate hikes from the Fed has increased over recent months. The expectation has also been noted by US companies, which have tried to front-run the potential for a higher cost of funding by issuing $147bn of debt in January. As the Fed raises rates, US companies could be modelled to issue 65% of their annual issuance of bonds in the first six months of 2022. This compares to a historical average of issuing 55% of total issuance in the first six months of the year from 2012 to 2019.
What does this mean for fixed income investors?
As we approach the beginning of the developed market tightening cycle, global portfolios should remain underweight duration in anticipation of higher yields. In addition, paring back exposure to risk assets while selectively owning high-quality credits is a reasonable strategy amid tightening financial conditions. Given the strength of corporate balance sheets, we anticipate tactically re-engaging with the broader asset class if, for example, risk premiums increase with intermittent bouts of volatility (short-term selloffs) or we witness greater discretion in the market’s pricing of credit risk.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum
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