Friday 18th June, 2021
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After a slow start to the week for investors, the Fed finally stepped into the breach to inject some energy into financial markets on Wednesday when the central bank released a surprisingly hawkish revision to its central forecast for policy rates. The consensus now among members of the Federal Open Markets Committee (FOMC), which is responsible for setting US interest rates, is for the next rate hiking cycle to begin one year earlier than previously anticipated (in 2023 instead of 2024). The shift in the so-called Fed ‘dot plot’ – which charts how each committee member sees the Fed Funds evolving over the next few years – was disclosed following a two-day meeting at which the FOMC confirmed that no change would be made to the policy rate just yet. Inflation data prints have been ticking up for some time, and market expectations for future interest rates were a few steps ahead of Fed guidance heading into the meeting as a consequence. The disconnect between the expectations of investors and officials has been causing jitters among market participants this year, and particularly among those who fear ‘too little, too late’ more than ‘too much, too soon’ in the context of monetary tightening. Indeed, a handful of doomsday investors have been predicting that runaway inflation would catch an overly cautious Fed off guard since the middle of last year given the epic scale of stimulus implemented since the pandemic swept the world. But the Fed has stood firmly with those in the dovish camp who expect that any price rises will be temporary and manageable. The change in guidance is hardly evidence of a paradigm shift in monetary thinking at the Fed: 2023 is still a long way off to begin normalisation. However, given the inflation blind spot that the bank had been showing recently, it is still a significant moment in the course of the economic recovery.
Like the Fed, and as discussed in our previous letter, we do not believe that the US (or the world for that matter) is on the cusp of a transformative era of higher nominal growth and/or inflation in the wake of covid-19, despite a few wayward data points. Many of these are being distorted (upwards) by the base effect of using last year’s readings to calculate YoY changes – as Q1/Q2 2020 prices collapsed amid harsh lockdowns – while the structural features that have kept rates and prices low since the 2008 Global Financial Crisis remain in place. However, we acknowledge that there is a wide distribution of possible macroeconomic outcomes at the present time given the unprecedented uncertainty infecting markets and the backdrop of massive fiscal and monetary easing. Therefore, we choose to remain diversified across asset markets in our portfolios and will never put too much weight on any one theme or idea.
Interestingly, the change in FOMC expectations did not result in a significant sell-off in US Treasuries on Thursday. Indeed, it seems to have had the opposite effect, precipitating quite a powerful rally across the US sovereign curve (and particularly in the belly and at the long end, resulting in a so-called bull flattening). Day-to-day market moves are notoriously difficult to attribute to specific causes, but this surprise outcome for government bonds could be evidence of a re-pricing of inflation tail risk. After all, the Fed has now given a nod to investor fears about the outside chance of spiralling prices and moved closer to the market consensus on the likely timetable for policy tightening; this reduces the probability that big rate hikes are needed in the future to contain surging inflation brought on by unduly loose policy in the face of inflationary pressures.
Elsewhere, the market movements were fairly easy to understand with a general sell-off across cyclical and reflationary sectors and assets being the norm. Commodities took a particularly big hit as inflation tail risks re-priced, the dollar rallied, and the timetable for hiking US rates moved closer (increasing the opportunity cost of holding these assets). Chinese regulators also threatened to flood the market with their strategic reserves of various metals and continued to crackdown on speculation and hoarding by state-owned enterprises and futures trading firms. In equities, while there have been few major moves at index level, the rates rally did cause a rotation from value to growth sectors as financials and energy stocks lost ground to technology, healthcare, and consumer discretionary stocks after the Fed’s meeting. This is a reversal of the trend year-to-date. How long it will last is not clear, but it underscores the need to avoid chasing short-term performance into themes that subsequently correct. In FX, the change in Fed forecast drove the USD higher vs. most other currencies. We have used the USD as a diversifier in non-dollar portfolios for several years, and we see the Fed policy shift as yet another reason to maintain this exposure. In our view, rates will undoubtedly languish for a long time in Europe and a wider differential should support the greenback despite Biden’s spending plans.
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