Another step toward policy tightening – with a caveat
- As expected, accelerating inflation forced the hand of the Federal Reserve (Fed) to initiate its first 25 basis point (bps) rate increase of this cycle, thus ending the pandemic-era zero-percent interest rate policy.
- In our view, high inflation has placed the Fed on a narrow path and increased the risk of policy error, with two potential outcomes – slowing growth and embedded higher inflation expectations – vying for supremacy.
- With our expectation that U.S. monetary policy will ultimately prove to be more dovish than many expect, we believe longer-dated bonds remain at risk to continuing inflationary pressure.
In a well-telegraphed move, the Federal Reserve (Fed) raised its benchmark overnight policy rate by 25 basis points (bps) on Wednesday (March 16) to a range of 0.25% to 0.50%. Perhaps more importantly, the U.S. central bank’s own forecast for the future path of rate hikes – as expressed in its “Dots” survey, which records each Fed official’s projection for the federal funds rate – increased to seven hikes for this year and four for 2023. In the December survey, these expectations were for three hikes in each of these years.
While some may interpret this as a continuation in the shift toward a hawkish bias, we are more circumspect. We believe that the seven 25 bps rate increases the futures market is pricing in for this year very much represent an upper limit of potential hikes and that this scenario is unlikely to materialize. Also, the current Dots survey comes with a considerable caveat: There were fewer voting members at this week’s meeting due to the ongoing transition in the Fed’s leadership composition and none of President Biden’s nominees have taken their seat. Importantly, we believe that eventual new members will lean toward the dovish camp, reinforcing our view that the market’s expectations have gotten ahead of reality. It’s worth recalling that throughout Chairman Jerome Powell’s tenure, when given the choice between two paths – and having not been mugged by multi-decade highs in inflation – he’s opted for greater accommodation.
About that Inflation
The reality that Chairman Powell has been unable to avoid is that inflation remains on the march. In February, both the headline and core U.S. consumer price indexes reached multi-decade highs – 7.9% and 6.4%, respectively. Market expectations for price increases to drift toward the Fed’s preferred 2.0% long-term range look slim. Inflation is expected to average 3.6% over the next five years based on the U.S. Treasury Inflation-Protected Securities (TIPS) market. For the 10-year horizon, the average is a modestly less ulcer-inducing 2.95%. We interpret these elevated levels as the market’s growing recognition that the Fed will be more tolerant of a pace of inflation seldom seen in the U.S. over the past three decades.
Yet the Fed faces a conundrum. Much of the current upward lurch in prices is due to supply constraints. The global pandemic famously caused supply disruptions in semiconductors and other important industrial inputs. Labor shortages have led to upward pressure on wages, which feed directly into inflation, especially in service-based economies. Unfortunately for the Fed, the blunt instrument of rate hikes tends to be less effective in combating inflation driven by supply factors than it is in quelling periods of accelerating prices driven by full-throttle demand.
A Narrowing Policy Path
The nature of this bout of inflation, which has been exacerbated by recent geopolitical events, amplifies our concerns about the potential for monetary policy error. Policymakers must perform a perilous balancing act. Should the Fed overtighten, the U.S. economy could slip into recession. If it falls behind the curve and higher inflation expectations become embedded, bond valuations could come under pressure as higher discounts are commanded to compensate for the diminished value of future cash flows.
The expected template of a methodical pace of rate increases in 2022 has been turned upside down. We believe that every Fed meeting has the potential to be “live,” meaning that a rate hike is possible. While it would likely be well-telegraphed per Chairman Powell’s modus operandi, we cannot rule out a 50 bps hike at some point.
The forced shift in the Fed’s stance, however, means that the period of “peak policy uncertainty” has likely been extended. Our view is that the Fed will make every attempt to proceed with caution. Yet, this same caution could lead to even more volatility in longer-dated rates as the risk of higher-than-trend inflation becomes fixed in investors’ minds.
Consequently, we believe investors should treat interest rate exposure – or duration – with caution. Longer-dated bonds, in our view, appear most vulnerable to elevated volatility. And given the relative flatness of the yield curve, the incremental return for holding farther out maturities may not be worth the higher risk. Lastly, the geopolitical uncertainty emanating from events in Ukraine further reinforces our view that now is not the time to take on any undue risk in one’s fixed income allocation.
Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.
Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.
This material has been prepared by Kapstream Capital Pty Limited (ABN 19 122 076 117 AFSL 308870) (Kapstream), the investment manager of the Kapstream Absolute Return Income Fund (Fund). Fidante Partners Limited ABN 94 002 835 592 AFSL 234668 (Fidante) is a member of the Challenger Limited group of companies (Challenger Group) and is the responsible entity of the Fund. Other than information which is identified as sourced from Fidante in relation to the Fund(s), Fidante is not responsible for the information in this material, including any statements of opinion. It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable to your circumstances. The Fund’s Target Market Determination and Product Disclosure Statement (PDS) available at www.fidante.com should be considered before making a decision about whether to buy or hold units in the Fund(s). To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Past performance is not a reliable indicator of future performance. Any projections are based on assumptions which we believe are reasonable but are subject to change and should not be relied upon. Kapstream and Fidante have entered into arrangements in connection with the distribution and administration of financial products to which this material relates. In connection with those arrangements, Kapstream and Fidante may receive remuneration or other benefits in respect of financial services provided by the parties. Fidante is not an authorised deposit-taking institution (ADI) for the purpose of the Banking Act 1959 (Cth), and its obligations do not represent deposits or liabilities of an ADI in the Challenger Group (Challenger ADI) and no Challenger ADI provides a guarantee or otherwise provides assurance in respect of the obligations of Fidante. Investments in the Fund(s) are subject to investment risk, including possible delays in repayment and loss of income or principal invested. Accordingly, the performance, the repayment of capital or any particular rate of return on your investments are not guaranteed by any member of the Challenger Group.