Second Quarter Total Return Outlook
Published on April 14, 2022
Russia’s invasion of Ukraine has exacerbated inflation, which was already rising. The big questions now are how far will the Fed be willing to go to slow inflation, and how will the market react as rates increase?
The geopolitical landscape changed dramatically in the first quarter, as news headlines shifted from the global pandemic to the war in Ukraine. Among the many consequences of Russia’s invasion, skyrocketing oil prices have triggered fears of runaway inflation, and we are now left to debate the impact on growth and inflation in the U.S. Meanwhile, we have yet to see the supply chain issues completely resolve, though we appear to be in somewhat better stead than three months ago.
The Fed has finally changed its tone and now appears to be singly focused on containing inflation. It has an unenviable task, but it is partly to blame for the current situation as its exceedingly accommodative monetary policy over the last year has left it in this very tenuous position. The question is now: Is the Fed fully committed to stopping inflation? If so, is it willing to sacrifice growth and possibly even drive the U.S. economy into recession?
In our prior outlook, we highlighted the options the Fed has in removing accommodation, and we believe these options to be more robust than the singular “inflation-killing” tone the Fed has recently adopted. To recap, these options are:
- To counteract an overheating economy, the Fed can raise the target fed funds rate.
- To contain inflation, the Fed can reduce its balance sheet more aggressively, which would effectively raise longer maturity rates while maintaining some “dry powder” for raising shorter rates more slowly.
- To counteract both an overheating economy and inflation, it can begin with hikes to lift the target rate off the zero bound but ultimately use both levers to affect the outcome that provides the softest landing for the economy.
Sadly, implementation of a dual-pronged quantitative tightening plan requires a level of finesse that the Fed is not known for. The Fed has taken to telegraphing its rate forecasts (“the dot plots”) as well as its open market operations in a way that makes changing course very difficult. In our opinion this policy of keeping the markets hyper-informed can be an impediment to implementing policy in the most efficient manner, but we doubt this is something that will change. If it did, imagine the market uproar – “does the Fed suddenly have something to hide?”
Thus far, the Fed’s approach has not been particularly well-received, as this year the Bloomberg U.S. Aggregate Bond Index delivered its worst quarterly return since 1980. In addition, the Treasury curve inverted, with shorter-maturity yields resting above longer-maturity yields – a rarity for this stage of a tightening cycle. In our view, the inverted curve reflects a policy error: leaving rates too low for too long, and then potentially hiking too late, and probably too much.
Were the Fed to adopt the balanced solution we advocate, it would be able to normalize the yield curve by selling its longer-dated bonds, restoring it to a shape that is more in line with market expectations. Steepening the curve would also address broader market fears that an inverted curve is a harbinger of recession, and it would allow the Fed to make fewer, shallower hikes at the short end. It would also allow the Fed to sell its longer-maturity holdings at lower yields than its shorter-maturity holdings, which would reduce the duration of its portfolio.
Instead, the Fed has made it clear that its preferred method of balance sheet reduction will come via runoff. In other words, it will simply allow its shorter-dated assets to mature over the next few years, which will confer none of the benefits we have just mentioned.
Given that the Fed is committed to its approach (including the probability of multiple 50 basis point rate hikes), the question is what does the bond market do for an encore? Will it deliver another quarter of painful losses, or will it find its footing and adapt? In our view, rate and spread volatility are likely to remain elevated. We expect the market will react to economic data prints or headline zingers from the Fed speaker du jour by extrapolating months of rate hikes based on a spot observation or quote. We believe the data that will matter most, besides the obvious inflation data, are surveys of economic activity, wages, and employment. We also believe that the notion of a 2% neutral inflation target is a figment of the past, and that the Fed would be happy with a 3% target in the intermediate term.
It is worth noting that we see a few positive signs that inflation may begin to cool on its own. In particular, there are three market factors that we believe have the potential to mitigate the current rise in prices. First, while nominal wages are rising over 5% annually, a CPI of 8.5% suggests negative real wage growth. Negative real wage growth is incompatible with the post-pandemic spending behavior we have observed. Second, higher mortgage rates should also dampen unsustainable growth in home prices and slow economic activity related to housing (or the wealth effect derived from housing or other assets that have shown signs of froth). Finally, as we approach the one-year anniversary of this inflation episode, base effects could dampen year-over-year comparisons of price data.
Longer-dated interest rates will determine where the market settles in its expectation for longer-term inflation. The TIPS market suggests we have some way to go in repricing the Treasury curve, and while we are sympathetic to a flatter curve, we feel this might happen at somewhat higher overall rates from here. In particular, we find shorter rates most vulnerable, unless the Fed changes its tack and embraces asset sales as a core part of its normalization strategy. Spreads across investment grade asset classes appear more compelling than at the start of the year, but challenges loom for risk-takers until the Fed can slow (or stop) the acceleration we have seen across all inflation measures. Higher volatility requires wider spreads as compensation, especially for MBS.
We would like to thank you again for your confidence in the team and welcome any questions or comments you may have.
Chief Investment Officer – Total Return
Vice President & Portfolio Manager
Vice President & Portfolio Manager
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Consumer Price Index (CPI) reflects the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.
The fed funds rate is the rate at which depository institutions (banks) lend their reserve balances to other banks on an overnight basis.
The Bloomberg U.S. Aggregate Bond Index (BC Agg) is an unmanaged index which is widely regarded as the standard for measuring U.S. investment grade bond market performance. This index does not incur expenses. The index includes reinvestment of dividends and/or interest income.
Investment grade bonds are those with high and medium credit quality assigned by a ratings agency.
Spread is the difference in yield between a risk-free asset such as a Treasury bond and another security with the same maturity but of lesser quality. Option-Adjusted Spread is a spread calculation for securities with embedded options and takes into account that expected cash flows will fluctuate as interest rates change.
A mortgage backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.
Treasury Inflation-Protected Security (TIPS) are a type of Treasury security issued by the U.S. government that is indexed to inflation in order to protect investors from a decline in the purchasing power of their money. As inflation rises, TIPS adjust in price to maintain its real value.
Duration measures the sensitivity of a fixed income security’s price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.
A yield curve is a graph that plots bond yields vs. maturities, at a set point in time, assuming the bonds have equal credit quality. In the U.S., the yield curve generally refers to that of Treasuries.
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A basis point (bp) is a unit that is equal to 1/100th of 1%.
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