Mutual Daily Mutterings
Quote of the day…
“Dear Sant, I’ve been good all year. Most of the time. Once in a while. Never mind. I’ll buy my own stuff.” – random meme
Chart du jour… Fed’s new dot-plot
“Couldn’t Hit Water If They Fell Out Of A Boat…”
Overview…”Fed smells the coffee, slightly more hawkish than expected…”
- All about the Fed last night, and while investors digest a more aggressive tapering agenda, and steeper rate hike expectations, stocks rallied…go figure! Treasury yields predictably rose, albeit at a modest pace, with a slight flattening of the curve. In the end, market movements, across stocks, bonds, credit etc, were modest….is what I initially wrote, but, then in the final hour or so of trading, US stocks went parabolic to close +1.1% – 2.2%.
- As expected by the market, the Fed last night signalled their intention to amp up their tapering efforts, doubling the pace at which they’re scaling back asset purchases to US$30bn a month (from US$15bn obviously). This will have tapering done by early next year and puts the Fed in a position where they can hike rates (earlier than previously anticipated) in order to combat inflationary pressures, if required. While the tapering move was anticipated, the path of interest rates was a bit of a Xmas surprise for most, being steeper than what analysts had generally expected.
- Projections published alongside the statement showed officials expect three 25 bps increases in the benchmark federal funds rate will be appropriate next year, according to the median estimate, after holding borrowing costs near zero since March 2020. This compares quite differently to the last update in September, when Fed officials were evenly split on the need for any rate hikes at all in 2022 (from median of 0.25% to 0.875%). Another three-hikes are factored in for 2023 (to 1.625%) and two in 2024 (to 2.125%).
- Fed sound-bites…on the sudden change in taper rates, the Fed flagged “inflation developments and the further improvement in the labour market” as the catalyst. The reserve further reiterated that it “is prepared to adjust the pace of purchases if warranted by changes in the economic outlook.” Market commentary has, quite rightly, been somewhat critical of the Fed’s performance through this cycle…”you are seeing a bit more panic instead of patience within the ranks of the FOMC, this is the first time we’ve seen the Federal Reserve chasing inflation in decades.”
- “The three rate hikes forecast in the Fed’s dot plot show a central bank that has slipped behind the curve and is forced to accelerate its tapering and rate hike timetables. This should flatten the curve as angst over a future policy mistake increase.” (Bloomberg)…well said that man / women / child
The Long Story….
- Offshore Stocks – Europe was mixed, but generally a touch firmer…not that anyone really cared on the day. Focus was on US markets and the Fed. Markets spent most of the day in the red, but then surged post the FOMC. The S&P 500 rose +1.6%, the NASDAQ +2.2%, and the DOW +1.1%. Despite the hawkish stance, despite the accelerated tapering, despite the faster than expected rate hike forecast, and despite the continued uncertainty of COVID and its merry children of diverging variants, US markets rallied strongly into the close. Why? A couple of sound-bites that might be relevant…perhaps, maybe. Firstly, during Q+A, Powell said incomes and consumer spending are very strong, while emphasizing the strength of the labour market. Secondly, a glass half full view of the Fed’s actions is the fact that the Fed is in fact taking action to combat inflation and therefore it won’t be a problem, i.e. a vote of confidence that they’re not behind the curve. That’s a lot of faith being thrown the Fed’s way…a little too optimistic for my liking. In the end, over 80% of the S&P 500 advanced, and only Energy (-0.4%) soiled the bed. Tech (+2.8%), Healthcare (+2.1%), and Utilities (+1.7%) topped the leader board.
- Local Stocks – a modestly meaningful and broad-based sell-off in local markets yesterday, with the ASX 200 retreating -0.7%, and 75% of stocks in the index sporting some red by day’s end. Utilities (+0.3%) was the only sector to fire a shot in anger, while the truly vanquished included Tech (-2.6%), REITS (-1.6%), and Telcos (-1.2%). With offshore markets inexplicably rallying again, futures are signalling modest gains on the open (+0.3%)
- Local Credit – a very slight improvement to the risk tone, if spread movements are anything to go by – a basis point tighter in the Aug-26’s (to +62 bps) and three-year (to +43 bps). Having said that, I’d suggest its more a reflection of dominant technicals that any meaningful change in investor risk appetite. New issuance is dead in the water for the remainder of the year, although I do remember Westpac once did a bond really late in the year, that settled on or around Xmas eve. It didn’t perform well. So, no new issuance expected for at least two or three weeks, yet some hefty maturities over the next month or so, north of $5bn in ADI maturities I think I recall reading somewhere (and $16.4bn of ACGB’s maturing). The first deal of 2020 was ANZ’s Jan-25, which priced before the first week of the year was done, at +76 bps. Tier 2 also nudged a tad tighter, -1 bps across the 2026’s (to +139 – 142 bps), the 2025’s (to +130 – 131 bps) and the 2024’s (to +101 bps).
- Bonds & Rates – local yields tracked higher yesterday, and the curve bull flattened, as expected given the prior sessions leads form US markets. With the Fed throwing down the tapering gauntlet (not a surprise) and projecting more aggressive rate hikes (somewhat a surprise), rates overnight predictably rose, albeit at a very modest pace, and off their intra-day highs. In the end US two-year yields were largely unchanged, and ten-year yields just +2 bps higher. “The big question for markets now is: can the U.S. economy digest this pace of hikes without ending up with a stomach ache? After the 20 months we’ve had, perhaps six hikes over a two-year period looks overwhelming. But compared to previous hiking cycles — most pertinently 2004 to 2006 when the Fed made 17 consecutive hikes — we are tentatively confident that the U.S. economy can handle it. Not only that, but US inflation needs it.” (Principal Global Investors). While the rates market agrees with the more hawkish stance of the Fed, just (next year’s dot plots), and did so well before the Fed went there, the market is however, more dovish than the Fed for 2023. OIS pricing for 2024 is below every Fed dot for that year, so, the market is of the opinion that more rate hikes sooner with reduce for rate hikes later, thus a shorter hike cycle.
- Some historical context on the Fed Funds Target Rate (‘FFTR’), it’s currently sitting at 0.25%, and has been at this level for around 60% – 70% of the time since the end of the global financial crisis. Since 1971, basically my life (yes, I turned fiddy during the sixth lock-down), the average FFTR has been just shy of 5.0%, with a peak of 20.0% in the early 1980’s. Leading into the pandemic, the peak FFTR was 2.5% (June-19), and it was 1.75% on the eve of the outbreak (Mar-20). A return to just over 2.0%, optically at least, should be reasonably digestible….although the sheer mountain of debt (government, business and household), that has been raised over the past two years does cause me some concern, and likely caps terminal rates. Local yields will likely drift higher today on the back of the moves in treasuries.
- Offshore Macro – more Fed sound-bites, “with inflation having exceeded 2% for some time, the committee expects it will be appropriate to maintain this target range until labour market conditions have reached levels consistent with the committee’s assessments of maximum employment.” A target is one thing, reality is another…. considering the last reading on inflation was 4.1% (Fed’s preferred measure, PCE), over 2x the target rate. And, with “supply and demand imbalances related to the pandemic and the reopening of the economy continuing to contribute to elevated levels of inflation” how is raising interest rates going to alleviate these imbalances? The FOMC’s median projection for 2022 inflation (Core PCE) was revised to 2.7%, from 2.3% in September, down to 2.3% in 2023 and unchanged at 2.1% in 2024. And it now projects the unemployment rate at the end of next year will be 3.5%, versus 3.8% in September.
- Local Macro – pilfering some commentary from NAB’s morning note…”RBA’s Lowe, Australian Jobs, MYEFO: A trifecta of market moving events. RBA Governor Lowe speaks at 10.30am on “The RBA and the Australian Economy ” which could be a scene setting speech as we break for the summary holidays. Of interest will be comments around QE and whether the RBA remains confident in their 2024/plausible 2023 rate hike view. As for the jobs figures we expect employment to increase 280k in the month, which is above the 200k consensus, and for the unemployment rate to fall to 4.9% from 5.2% (consensus 5.0%). Also expect MYEFO to be released during the day. We pencil in a 2021-22 deficit at around $75bn from the currently projected $106.6bn”
Another set of Steak Knives…”A Behind-The-Curve Fed Risks Policy Error” (Bloomberg)
- The three rate hikes forecast in the Fed’s dot plot show a central bank that has slipped behind the curve and is forced to accelerate its tapering and rate hike timetables. This should flatten the curve as angst over a future policy mistake increase.
- Until this point, the Federal Reserve had been successful in decoupling eventual rate hikes from its asset-purchase tapering. As they move the tapering timetable up, Fed officials have said they are simply looking to create optionality. They want to wind down the asset-purchase program and then take a look-see at where inflation and employment are and re-assess.
- Expectations for rate hikes have moved forward aggressively. The Fed has validated those expectations with the dot plot. But it erred when it changed its yardstick for ‘transitory’ inflation. Having originally said inflation would moderate after the U.S. summer and it would react otherwise, it then said it could show patience and wait until mid-2022. Had it stuck to its original timetable, it would have been able to taper earlier. But now it is boxed into a corner where it needs to taper asset purchases as quickly as possible and then hike right on the back of that. It can no longer claim tapering and rate hikes aren’t co-dependent.
- The biggest wildcard is the omicron variant of Covid-19 and what that means for economic growth and inflation. In China, officials are under pressure to keep Covid cases out of the country in the run-up to the 2022 Winter Olympics. The problem is that omicron makes this difficult without severe restrictions. And those restrictions will snarl supply chains, adding to inflationary pressure and putting the Fed further behind the ball.
We may find, as this holiday season ends, that omicron has a greater impact on keeping inflation elevated than it does in slowing economic growth. And that would fully re-couple tapering and rate hikes, raising fears the Fed is behind the curve.
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Scott Rundell, Chief Investment Officer
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