Federal Reserve: Same dovish tune with more hawkish melodies
Investors should maintain a below-benchmark duration profile, while adding to extended sectors like credit and emerging market debt as the global recovery gains momentum.
Global Market Strategist
Inflation will likely continue to dominate the market narrative through the remainder of the year, particularly as both headline and core inflation run above the Fed’s 2% target. For investors, the most consequential issues will be the Fed’s reaction function to higher inflation and strong economic growth and how bond yields respond.
The Fed continues to assert that the rise in inflation as the pandemic winds down is transitory and therefore should not prompt any changes to interest rate policy. While long-run inflation expectations have risen above 2%2 and the perceived “stickiness” of higher inflation will continue to be hotly debated, on balance, the market appears to be in agreement with Fed officials. As highlighted in Exhibit 5, the inflation curve, as measured by CPI swap rates, has deeply inverted. In other words, markets are expecting meaningfully higher inflation over the next two years, than over the next five years.
While transient inflation and labor market slack should support the Fed’s near zero policy rate stance at least until sometime in late 2022/early 2023, a rapidly improving economy will likely cause a change of tune regarding its bond purchase program sometime this summer. In fact, based on minutes from its April meeting, “a number of participants suggested that if the economy continued to make rapid progress toward the Committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases.” Given this, we expect the committee to lay the groundwork for tapering this summer, and announce a timeline at its September meeting. Regarding rates, the FOMC is likely to strike a more hawkish tone through its updated economic projections and “dot plot” later this month.
We expect the median dot to reflect one rate hike sometime in 2023 and for modest upgrades to its inflation and growth forecasts this year and next.
Exhibit 5: Markets expect high inflation to be transitory
5-yr. Inflation swap rate - 2-yr. Inflation swap rate, daily, basis points
One of the more perplexing developments in recent weeks has been the stability in long-term bond yields as inflation and growth expectations continue to move higher. One theory is bond markets have already priced in much of this strong data. Going forward, it may be the case that economic data will need to surprise to the upside relative to expectations for yields to break out of their trading range. As shown in Exhibit 6, changes in long-term yields closely track the magnitude of economic surprises. Earlier this year, the economy was handily beating expectations and nominal yields rose as a result. Since then, however, yields have remained range bound as economic surprises have moderated.
Exhibit 6: Data in line with expectations translates to less rate volatility
Rolling 3-mo. Change in 10-yr. Ust yield (bps) and citi economic surprise index
So, what could cause the next leg higher in yields? We think a shift in the Fed’s tone around tapering the balance sheet could be an initial catalyst. In addition, as the labor market recovery picks up steam again, particularly in the fourth quarter as enhanced federal unemployment benefits expire and elevated job openings and higher wages attract workers back into the labor force, yields should grind higher. Moreover, as further fiscal stimulus is passed, increased borrowing at the same time the Fed is easing up on Treasury purchases should also act as a headwind for bond prices. All things considered, we expect the 10-year Treasury yield to end the year between 2.0% and 2.25%.
Overall, navigating fixed income markets will be challenging over the next 12-18 months as nominal yields grind higher and robust economic activity keep credit spreads tight. Investors should maintain a below-benchmark duration profile, while adding to extended sectors like credit and emerging market debt as the global recovery gains momentum.