As Expectations Of A Fed Pivot Fade, What’s Next For Fixed Income?

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Fed Chair Jerome Powell’s hawkish tone following the most recent Fed meeting is signaling interest rates may stay higher for longer. Greg Bonnell speaks with Scott Colbourne, Managing Director, Active Fixed Income at TD Asset Management, about the potential implications for the bond market.

transcript

Greg Bonnell: Of course, markets did try to take some time to figure out what we exactly got from Fed Chair Jerome Powell yesterday afternoon. We are now, sadly, to the downside in the wake of all of that. Investors, at least some of them, are out there thinking perhaps there’s no pivot coming any time soon. Let’s bring in Scott Colburn, Managing Director of Active Fixed Income at TD Asset Management. Scott, let’s try to run down what happened. It was a wild afternoon yesterday afternoon, obviously.

Scott Colburne: Very wild, yeah.

Greg Bonnell: We seem to have come to maybe a bit of a market consensus as to what we got from Jerome Powell. what was it?

Scott Colburne: The statement was basically clear, that rates still have to go up higher, but the acknowledgment that monetary policy works with lags, and there’s a cumulative of effect on the economy of those lags. And so that, to the market’s initial reaction, was sort of a positive reaction, because we had hoped for some sort of acknowledgment of a pivot or a slower pace of rate hikes. The press conference with Governor Powell sort of dampened everything. And basically, he framed it three ways. He said, look, first we have to think about the pace. And we acknowledge that the pace has been very rapid. And that pace is going to change going forward. And we’ve seen that in other central banks, the Bank of Canada, as you just mentioned. So the pace is gonna slow for sure. But he’s switching the focus to the destination, the end of it, where in our world, the bond world, it’s called the terminal rate. And where is that rate? And he acknowledged that, since September, when we last sort of got an update on their forecast, it’s higher than when it was then, which was about around 4.5%, 4.75%. So, we’re gonna have a higher terminal rate, and we’re not exactly sure. And so that dampened the market’s expectation. And certainly, the duration of this sort of tightening cycle will be longer. And the combination of the latter two of those bullet points, the higher terminal rate and the duration of that, vapors markets. And bonds moved higher, flattened the curve. So the short rates moved higher than the longer rates, and then certainly it had a dampening effect on the equity market.

Greg Bonnell: It was interesting, as you said, the statement. And the statement did give you that little bit of indication, like we got from the Bank of Canada. Hey, we’ve done a lot, and maybe we need to reflect on what we’ve done. But then, as you said during the press conference, it felt like the Jerome Powell that we got at Jackson Hole.

Scott Colburne: Exactly.

Greg Bonnell: You go into this event thinking, oh, he’s probably gonna tell us. Don’t worry. We’re gonna ease up, and we’re gonna not cause too much pain, and just very stern. If there was one word that stuck out to me, he just seemed that he’s on that stern path.

Scott Colburne: And he acknowledged, if you look back in history, the mistake is being premature in moving, pivoting, cutting, pausing. That’s history’s lesson is that don’t be premature on that. If anything, he’s gonna err on the side of over-tightening, and– rather than under-tightening. And so that is definitely a stern message.

Greg Bonnell: So that takes us probably through the end of this year and into 2023. You talked about the endpoint and the duration of hanging around that end point. And as you said, Chair Powell, indicating– we didn’t get a fresh dot plot, right?

Scott Colburne: no.

Greg Bonnell: That didn’t come this —

Scott Colburne: December.Greg Bonnell: –time around. So that seems to be a hint that when we finally end up at that place where we want to be, maybe it’s higher than you previously thought. And we’re gonna stay there for some time. What does that do to the markets?

Scott Colburne: Well, from a bond investor’s point of view, it means that we continue to have pressure on the front end of the yield curve, and short end rates going up more than longer end rates, which is flattening of the yield curve, and in general , all rates higher. So we’re gonna continue to see bond yields higher. And the destination, now we have a lot of speculation. Where does the Fed funds rate go? Now it’s at 3.75% to 4%. Is the destination 5%, is it 5.75%, is it 5.5%? So I think it’s probably 5%, 5.25% is where I would land on. But we’ve seen the domestic US economy, particularly the consumer, the jobs market, remain resilient. So we’re gonna start to– we’re in the data dependent world. They’ve definitely emphasized that. And we’re gonna get new data tomorrow, on Friday.

Greg Bonnell: That feels like a buckle up kind of thing, right?

Scott Colburne: yeah. So we’ll get the jobs data. Maybe– it’s definitely the pace of jobs growth is slow, but it’s still solid. The Fed acknowledged that yesterday. They said, look, things haven’t really ratcheted down on the job side, and it’s too strong to even begin this pivot process. So we’ll see that. We’ll see CPI next week. So there’s definitely a data dependency element to this. But I think we have some way to go.

Greg Bonnell: When it come– you mentioned the fact that– and Jerome Powell saying it too– that the labor market is still strong and it’s still tight. When it comes to inflation, are we getting any sense that central banks are starting to win this fight, even just– perhaps not even winning it, but putting a dent in it?

Scott Colburne: yeah. I mean, when we first started to discuss the oversize and the overshoot on inflation, it was COVID shocks. It was supply chain. It was inflation and energy shocks. And that is definitely waning. We’ve definitely seen a turn on that side. We’re seeing the evidence that the rate of increase in headline CPI is going down. So all that is working in favor of a lower inflation in next year. And when you look into the bond market details, it definitely shows that inflation is going down. Headline inflation is closer to 3% in the second and third quarter of next year. That being said, the core, the labor market, the sticky element of core inflation is the challenge. And so, to the central bank’s point, particularly the Fed, it has some way to– more ways to reduce demand here, to equilibrate the supply demand imbalance in the economy.

Greg Bonnell: Before we get off the central bank discussion, the Fed obviously very important– not the only central bank in the world. We heard from the Bank of England today, right? And it didn’t sound like good news to me.

Scott Colburne: Look, they raised rates 75 basis points. But they did push a little bit back on how far rates are going to go. So that was a little bit of a surprise to the market in the sense that Governor Bailey said, look, we’re gonna see– if we follow what’s priced into the market and the path that’s priced into the market– that we’ ll see a sustained period of recessionary growth. And I think that surprised the market a little bit. But there’s definitely room to continue to see rates higher. I think this is the challenge for all central banks. The Bank of Canada acknowledged it, Bank of England today, acknowledgment. We’re going into– a low growth environment, is it recessionary? How deep of a recession next year in 2023? And that has implications, obviously, for bond markets, equity markets, credit markets. And not all economies are going to be aligned as we have over the last year. We’re gonna start to see that differentiation emerge.

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