Did the market get it all wrong? Is the Fed just guilty of a communication error or is a ‘redefined’ framework now haunting investors? What if market participants are just panicking because their summer plans now include more uncertainty?
The main surprise was that the ‘dot plot’ now implies two interest rate rises before the end of 2023. Importantly, this points to concerns at the Fed over upside inflation risks. That is a departure from its prior characterisation of inflation as transitory.
Chair Jay Powell unsuccessfully attempted to play down the dot plot and went on to say there is “the possibility that inflation could turn out to be higher and more persistent than we expect”.
Inflation: Transitory or pressures building?
It has been our view for some time that the recent surge in consumer price inflation is due to base effects and supply bottlenecks as the US economy exits lockdowns and resurgent demand meets disrupted supply chains. However, cyclical and structural risks to inflation have also risen in the form of higher rents and wages. This has built in more persistent inflationary pressure in the background.
What did the dot plot say about inflation? Although there were upward revisions to the 2021 inflation forecasts, the 2022 and 2023 forecasts remained almost unchanged. To us, this looks curiously like a transitory spike.
Source: Federal Reserve, BNPP AM; June 2021
The hawkish tone continued as Chair Powell changed the way he talked about the pace of the economic recovery: He highlighted that the US labour market and recovery had actually strengthened and temporary constraints on hiring would gradually diminish.
Although the Fed left the pace of quantitative easing unchanged, Powell alluded to the fact that discussions on tapering the billon-dollar asset purchases under QE had begun as he said the phrase ‘talking about talking about tapering’ could now be retired.
The market was both surprised and caught off-sides: 10-year breakeven inflation (BEI) narrowed from 2.41% to a low of 2.21% (see exhibit 2), the yield spread between five and 30-year US Treasury bonds flattened from 140 to 107bp and the benchmark 10-year US Treasury yield fell from 1.49% to 1.55%. This caused investors worry that the reflation trade was dead.
The moves led us to immediately reconsider our long BEI and nominal curve steepening positions.
Not all dots are created equal
One interpretation of the market surprise is that this is just a communication error by the Fed and Chair Powell does not control the dot plots and even attempted to de-emphasise their relevance as just conditional forecasts.
Also, John Williams and Richard Clarida, members of the policy-setting Federal Open Market Committee, may indicate that the dots that matter are still indicating no rate rises (i.e. Powell, Williams, & Clarida).
Powell’s post-FOMC testimony to Congress on June 22 was an opportunity to soothe the market and it did convey a more dovish tone as he remarked that he was not concerned about an overheating economy.
A misunderstanding of the inflation framework
Prior to the FOMC, the market may have assumed that the Fed was trying to make up for past inflation undershoots, but now the lookback period and the start date of that period have been called into question.
Investors may have assumed that the Fed would generate a period of inflation overshoots – to perhaps 2.25% - by allowing the economy to ‘run hot’ to ‘make up’ for years of inflation undershoot after the Great Financial Crisis. This would imply a lookback period that started well before the announcement of new FAIT average inflation targeting framework in August 2020.
Added to market frustrations, Chair Powell declined to clarify and specify a start date, saying “it’s discretionary, not formulaic”.
However, by examining Clarida’s ‘light’ version of FAIT (conditions for delayed rate lift-off followed by flexible inertial Taylor rule), average inflation of 2% is set as an objective, but not a requirement.
What this tells us is that the Fed is not following the framework as aggressively as we thought. This is significant because
- Rate rises don’t require an inflation overshoot to have even commenced
- The Fed’s tolerances for inflation overshoots are actually much shorter than perceived by the market and any sign of inflationary pressure could lead to further tightening policies.
A market overreaction
There is also the possibility that the market is overreacting causing a widespread panic and second-guessing of the reflation trade.
There is a lot of position squaring going on and a position washout of bear steepeners and BEI wideners. Big moves in the curve, breakevens and USD are all indicating an unwind of the reflation trade.
The look-ahead at the investment implications
We now have a Fed that seems concerned about – rather than encouraging – inflation overshoots and higher inflation. In our view, QE tapering will start in early 2022. The signals will first come in September at the Jackson Hole Symposium.
Our new timeline for rate lift-off is set for early 2023. This is much sooner than previously forecast. As a result of policy uncertainty coupled with a Fed that is less tolerant of higher inflation, the market will be hypersensitive to non-farm payroll (NFP) and inflation data, leading to higher volatility in the near term.
From an investment perspective, we believe the new fair value for 10-year BEIs is at around 2.35%. BEIs will now be driven by what happens with actual inflation, so our focus shifts from the 10-year to 5-year sector.
We still believe real yields will rise, supported by the recovery and an accommodative fiscal backdrop, but not driven by a widening in BEIs, and we will look to add to our real yield duration underweight.
On the yield curve, we hold a nominal curve flattening bias as lower inflation expectations, lower BEIs and less inflation risk premia will predominantly impact the backend of the curve. Therefore, we are reducing our nominal steepeners, but are also cognizant of the fact that flatteners do involve negative carry and would look to trade tactically around the release of NFP data.
Lastly, lower breakevens and lower peak policy rates mean a lower target for the US 10-year 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 with a US nominal yield curve steepener, long US BEI position, and a modest underweight in duration. Since the meeting, we have:
- Reduced our real yield exposure by selling 5-year 5-year forward real yields
- Reduced our nominal yield curve steepener
- Reduced our long BEI position
We intend to reduce our nominal yield curve steepener and long BEI positions further, and will look for opportunities to increase our underweight in real yield duration.
Any views expressed here 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 hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
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