Markets brace as the Fed embarks on a historic unwinding of policy

James Wilson

Jamieson Coote Bonds

Interest rate hikes and global inflationary pressures, as well as the withdrawal of stimulus programs and geopolitical risks, are expected to increase volatility across financial markets in 2022. As investors adjust to the next phase of the economic cycle, understanding these risks and how they will feed into the global economy will be key to defending portfolios.

In a recent interview with Luke Mandekic, Head of Research and Consulting at Channel Capital, I discuss the latest policy changes, both locally and abroad, and explain the potential impact on markets, which may help fixed-income investors navigate the challenges ahead.

This short video covers:

  • Valuations across global bond markets and the likely pathway for monetary policy.
  • The outlook for inflation and labour markets in 2022.
  • The current credit market environment and potential risks to be wary of.

Edited transcript

Luke Mandekic: It's certainly been a rocky start to 2022 and bond markets have obviously been at the height of some of that volatility with central bankers turning to a more hawkish stance. If we look locally first, the RBA's probably a little bit further behind the pack in terms of where they are in reducing stimulus. What was your take on the RBA board meeting last week, and some of the comments that came out of that?

James Wilson: That's right, Luke. So to begin with, we're in a position in global markets where we talk about different central banks having divergence in that they're going in different directions, and we're looking at opportunities in the way that markets going to operate this year. But really what's happening is it's all converging. And what that means is rates are going one way and that's higher. So what happened at the RBA last week is they began the next steps towards their policy normalisation, which means they've started talking about rate hikes which may now happen towards the end of this year. They talked about unwinding their balance sheet which has been extremely accommodative measures that effectively stopped QE as at the February meeting, ending their last bond-buying program this week and then they'll start to unwind the balance sheet later in the year. 

We also got a bit of extra information. RBA Governor Philip Lowe also spoke at the National Press Club, and he talked about what it meant to have sustained inflation. And he actually loosened up the term. So we always thought it was two and a half, in the middle of a 2% to 3% range for inflation and wages wanting to see a 3% handle. But what he actually did was walk that back and talked about looking at some of the softer data points. So things like chatting to businesses, business liaisons are a big part of what the RBA does. So getting information about what they're doing about wages, seeing bonuses, how they're being paid, looking at some of the AVS payroll numbers. And so by understanding that, not that it gives more clarity, but it allows us to understand how the RBA is going to behave this year and how we can react to that.

Luke Mandekic: Yeah. And interestingly, the markets really moved quite aggressively ahead of the RBA own's forecast and we're now pricing in multiple rate hikes just for this calendar year alone. What's JCB's view on valuations across the curve at the moment?

James Wilson: If you go back to the start of 2022, it's been a really interesting year for bond rates. So we opened up with the US Fed looking a lot more hawkish than the market had been expecting. So more hawkish meaning they noted really tight labour, inflation numbers have been higher. We're now pricing in a much steeper rate hike curve in the US. And what's happened this year following that, is that the Australian bond market has actually moved one for one with the US bond market. So right now, and I was just looking at my desk before, if you look at the 10 year yield in US treasuries, which is the global risk free rate as the market looks at it, that has sold off, so gone higher in yield 44 and a half basis points since January 1, the Australian 10 year bond has gone 45 basis points. So it's literally one for one when you've got this divergence of policy so far, where the RBAs said that they want to be patient and they're looking through and want to get more information and more inflation prints, more job numbers, whereas that the US is more likely to be hiking rates as of next month. 

So how do we look at that? Well, in a pure evaluation sense, Australian bonds do look like they've oversold and got fairly cheap and quite attractive at an absolute yield level. But what we do know is that we're in a global pool of capital and Australia needs to have that little bit of a discount, so it needs to be a little bit cheaper to make it more attractive to offshore buyers rather than holding the risk free rate of US treasuries. And that's why we can continue to potentially underperform US rates.

Luke Mandekic- So looking further abroad, you mentioned the Fed a few times, they've really been quite vocal in terms of bringing forward expectations of policy normalisation. You suggested that potentially we're looking at a rate hike in March. What's your expectation for Fed policy throughout the rest of 2022?

James Wilson- So the key metrics that the Fed is looking at this year will be the Fed funds rate and the unwinding of a balance sheet that's become extremely bloated over the last two years of the extreme policy. The most recent CPI number was at 7%, which is the highest rate since the early 1980s, we've got the jobs number at 4% or thereabouts which is effectively full employment. There's no way that a central bank in their right mind can keep rates at extreme policies as they are right now. 

So we see the Fed beginning their rate hiking cycle for the first time in about three years with the March rate hike. The market's actually potentially pricing in a 50 basis point hike. We don't think that they'll go that far. And then we'd expect to see in the order of five rate hikes over the rest of the year in the last seven meetings. 

There's actually every chance that they could do seven rate hikes with the level of inflation right now, versus the jobs number and versus how accommodative we are. 

On top of this, we expect them to start unwinding their balance sheet. That will happen where they reduce the amount of bond buying they're doing to the point that they start letting it roll off later in the year. Now, this in itself is going to have large impacts on risk markets potentially. 

At no stage in history have we seen such an unwinding of accommodated policy, we've got a huge balance sheet that needs to be unwound plus the unwinding of the zero interest rate policy. And we think that in itself will create volatility through the year and will create opportunities as well.

Luke Mandekic: And so on top of that, we're also likely to see one of the biggest fiscal contractions in modern history as governments globally start removing some of those emergency spending packages. Do you think that investors are paying enough attention to that change? And what do you think might be some of the shorter and medium-term impacts?

James Wilson: I think you have to think of what's happened with these fiscal spending, so come in different ways, you've had, which is the Federal Reserve and global central banks everywhere, in the bond-buying programs, you've had stimulus cheques going direct to the consumer. This money's being put into assets, so it's being put into stock markets, it's being put into housing markets, it's being put into retail. And so it was something that central banks needed to do in the situation we've seen. Unwinding this, there have been tens of trillions of dollars of stimulus put through the market, like extraordinary amounts. And so what's going to happen is there has to be a slowdown. How quick that'll happen, and how that'll come through in markets, probably yet to be decided. Even the most recent earnings season in the US has seen in the order of 75% of companies beating their expectations. So that means earnings are still going okay. You know, the world hasn't stopped, but we haven't actually seen the full stimulus withdrawn. And we're still at extremely stimulatory levels of rates and liquidity. 

So when that does slow down, only time will tell, but it's not going to be positive for risk markets. 

We've already seen as the Fed has become more hawkish, we saw a massive drawdown in equities in January and February. Tech stocks, so the NASDAQ was down in the order of 15 to 17% at one stage, S&P 500 was down about 10%. Locally, the Australian equity market was in the order of 8% down. And that has bounced back a bit in time. But the market hasn't seen in the last 10 years that sort of withdrawal of liquidity and rate hikes. So I think credit markets may see a bit of a shift towards more neutral from being heavily, heavily overweight as the year goes on.

Luke Mandekic: We certainly can't have a conversation without discussing inflation. So globally inflation's continuing to heat up. We're starting to see that trickle into wages now as well. What's JCB's outlook for inflation and labour markets in 2022?

James Wilson: You're right, inflation is at extreme levels. Like, as I mentioned a minute ago, we're talking 1980s, the last time we saw inflation here, US inflation at 7%, European inflation is at 5%, New Zealand inflation is at almost 6%, Australian inflation is a lot lower, so it's about 2.5% but we have various reasons for that. You know, it's a quarterly review, we have different products in there. You know, for example, US inflation includes things like used cars which have soared as we haven't been able to get new pieces, we've had supply chain issues that have been dominant globally. 

The zero-COVID policy in China has added to inflation because they are, and will probably continue to be the engine room of manufacturing for the world. And so if they shut down, it means things just can't get made, we're short of different parts, they're not getting assembled, shipping containers are in short supply. 

So what does that mean for the rest of the year? Well, it will stay high for a little bit, where it will settle, will US inflation get back to 2% by the end of the year? Probably not. But what's going to happen is we will see supply chains open up a bit, and we're starting to see that a little bit now. So we've gone through a period where, I don't about know about you, but I've just been buying stuff. You know, I haven't been able to do stuff, so I've been buying stuff. And I've been sitting at home and looking at my window and seeing the lady next door get a FedEx and an Aus Post and a delivery every day. And I just know that that's where people are spending money. We haven't been able to go to restaurants, we haven't been able to go to the cinema's, so there's just an experience we haven't been able to do. 

In time as Omicron has come, and hopefully we've seen the peak of that, and it seems to not be having such a huge economic effect globally. I think that level will sort of even out. So we'll go back to doing things, having fun, hope we can one day Luke. But what does that mean? You know, we look at different data points like the Baltic Dry Index, which is a shipping index and that's come from extreme levels back to sort of a more level playing field. When you look at that, that means that these supply chains are really starting to unwind a little like the issues that we've been seeing. So in time, I think inflation can potentially keep rising a bit, but then the other thing about inflation is the base effect. So the actual inflation number that you see is the rate of change of inflation. So oil's a big part of inflation numbers. If that goes from $40 to $80, that's a 100% increase. If it goes from $80 to $120, it's actually only a 50% increase. I'll say only, you know, it's still going to hurt you when you fill up your fancy car. But what that does mean is that it does peter out over time. And so we're going from prices at one level to a reset of prices. So sure, it'll be more expensive, but the way the maths works, it just can't keep on going up forever. 

Luke Mandekic: Well, I'm on a first-name basis with my local Aus Post delivery by now thanks to the wife and kids. So I certainly understand where you're coming from.

James Wilson: Thanks Barry.

Luke Mandekic: I did want to touch on credit markets as well because they've been surprisingly benign in recent months despite the volatility we've seen elsewhere. What's your take on how credit markets are behaving and are there any sort of looming risks out there that you're sort of wary of at the moment?

James Wilson: So interestingly, with a lot of the credit markets, the way they make up the indices is, like you say, they've been quite benign and very well behaved. One thing to think about, especially in the junk bond index is that there are a lot of energy producers in there. So what we've seen in the last, especially since the start of the year with oil up in the order of sort of 20%, natural gas up in the order of 30% year to date, is that those energy producers are actually doing really well because they're making a lot of money from you and I but it is what it is. So that's actually kept junk bond spreads really low. You might remember a few years ago when oil crashed and credit markets went wider because again, it's led by the energy producers, now that's not a total story of the whole credit market, but what it does mean is that part of the complex is staying cheap. 

Now, what will happen to credit markets? Look in time, and we saw this in 2017, we saw this in 2008, when the Feds start hiking rates and through these big cycles, credit does start to crack. 

You get to a point where, why would I own a BBB bond at, call it 3% when I can own a US treasury at 2.5%? It just doesn't make sense. You know, so you might as well be getting the government rated fully guaranteed risk-free yield, and then you need to have credit yields repriced to take all that in. So as we say, they've behaved very well so far. The rates market and the rates complex is often the front of this locomotive of risk markets. And rates make up and global bond yields make up a lot of the reason of where global markets are, where they are, cheap money, discount rates, make everything look cheap, investment, but once they do go up, it can really change the story quite quickly. 

And I'll tell you what, when that changes, the door to get out can get very small, very quickly.

Luke Mandekic - I think we can probably all agree that this sort of heightened volatility is going to be with us for the foreseeable future as people adjust to this next phase of the cycle. How are you and the team managing risk in your portfolios in an environment like this?

James Wilson - Well I think you have to be nimble and you have to be humble. We're coming into a world where we've lost a non-price sensitive buyer in the US Fed and the RBA is going to do the same and the ECB at some point will do the same, that you actually are losing that player in the market, which means prices can and most likely will reset to a point. And that's when you find the global pool of capital will reprice and you will get a level but that means credit's going to struggle to find a buyer, equities might get hurt. It's not going to be a straight line. And so what we do try and do with the team on the desk is make sure we're disciplined. That's the key to it. So I don't think this year, you need to take huge punts. We all expect, well, we do expect that rates will be higher in the complex, but at some point, you find that terminal level and rates can come low. And there will be an opportunity to really load up on duration, looking for lower bond yields. 

So what are we looking at? We are looking at different parts of the supply chain, how that's going to turn around, very close eye on inflation, very close eye on wages and how they're going to turn. Obviously, we are keeping a very close eye on risk markets as well. But the key will be not to fall in love with the position because again, we talk about the divergence of different asset classes. It's going to create opportunities. And so we want to have enough capital and dry powder to be able to take meaningful positions when that happens, but for now, and probably for the next couple of months, I think there's going to be enough volatility where we don't need to throw the kitchen sink.

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James Wilson
James Wilson
Senior Portfolio Manager
Jamieson Coote Bonds

James is responsible for managing investment strategies for institutional and retail clients at Jamieson Coote Bonds (JCB). Prior to joining JCB, James was Senior Portfolio Manager, Fixed Interest and Absolute Returns at VFMC where he was...


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