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Over the past 5 years central banks have been preparing, informing and guiding financial markets in an extremely transparent manner through detailed minutes. Participants adjust positioning the moment new biases are revealed by monetary authorities with respect to economic estimates, risk assessments and changes in reflections on policy rate setting. Correctly assessing the trajectory or shape of the central bank’s reaction function is like finding the holy grail. The latest FED minutes, released on January 5, revealed that 15 out of 18 FED governors expect upside risk to the key core PCE (Personal Consumption Expenditure) inflation index. Core PCE for November printed at 4.7%. The December reading is expected for January 28, 2 days after the January 26 FED meeting.
Offering clear forward guidance has served its purpose. Proper forward guidance gives rise to financial market stability, not instability. Spikes in market volatility following the release of minutes stem from groups of market participants that panic, call for immediate action and feed a narrative that central banks have lost control and are behind the curve. Yet, central banks are very well informed, their output reveal high quality analysis. Perception often gets it from reality. In December it became very clear that the liquidity provisioning (active QE) way would come to a sudden stop end of Q1 2022. Out of the 2022 blocks, the US yield curve shifted higher in a parallel fashion of about 24bp within the 5 to 30-year maturity bucket. 2-year rates lagged adding ‘only 13bp to finish at 0.86%’. 10-year US Treasuries added 25bp jumping from 1.51% to 1.76%. The 10-year rate 1-year forward closed at 2.00%. That is about the consensus level of 2.05% for US 10-year rates that a broad panel of economists tracked by Bloomberg called for end of 2022.
The track has been cleared for the FED to implement what is priced today: policy rate lift-off in March followed by an additional 2 or 3 hikes over 2022. So, when US FED fund futures have priced 3 to 4 hikes over 2022, 2023 adds another 2 hikes to finish this cycle at 1.50%-1.75%. The FED roadbook for the next 1.5 years is written. Expect that Powell and Brainard confirm these expectations this coming week during their Senate hearings, leading to his reconfirmation as FED Chair and her confirmation as FED Vice-Chair. Whether the FED starts tinkering with active Quantitative Tightening (QT) over H2 2022 is still food for debate.
Balance sheet reduction (putting caps on monthly reinvestment) percolates quickly into tightening of financial conditions. Banks’ willingness to increase money supply through credit provisioning might buffer this tightening but might fall short if client demand is not at the party. Anyway, announcing QT too early might be a signal that will confirm that the terminal rate will be achieved below 2.00%. The previous episode of QT over 2018 should be revisited! The balance sheet QT process weighs more and impacts faster on financial conditions than rate hikes.
The above set of events caused a spike in implied equity volatility but, for the awake observer, caused a drop in implied bond volatility! Equity markets got stirred as real rates spiked as much as nominal rates. The game can start by predicting when we might print the first negative month-on-month inflation print. Be aware that such prints work in reverse on inflation expectations. It’s a bit like the pandemic numbers leading to a steep wave up, followed by steep drops as the intensity abates. Inflation readings will show a similar pattern, of course, stretched out over years instead of months for corona infections. It requires reflection today on how we will behave once we reach the episode of declining inflation rates. Already, expect more upside pressure on (negative) real rates than on nominal rates. Over H2 2022 and 2023 we should not be surprised to witness downside pressure on inflation expectations. Over the Dec 2015 – Dec 2018 FED hiking cycle 10-year inflation expectations fluctuated nicely around 2.00%. Today we have 10-year US inflation expectations settling around 2.50%. In the previous rate hiking cycle, the terminal rate rose to 2.5% with 10-year nominal rates making highs just above 3.00%. As markets settle for a terminal rate of 1.50%-1.75% today, we might see highs on 10s around 2.25%. That would be highly promoted as a buy opportunity. With government indebtedness having risen by about 20 percentage points to GDP over the past 2 years that might indeed become a level to hope for…more debt means less real growth potential means the credo ‘low for longer’ with respect to long-term rates might do extra times. That brings me to equity markets. These should keep a close eye on real rates.
Episodes of rising US 10-year real yields (rising 26bp over the week to finish at -0.76%) have a distinct negative impact on Information Technology and Health Care as these companies often exhibit ‘long duration’ earning models. The opposite goes for Energy and Financials, as higher real rates reflect a promising growth cycle and increasing rate intermediation potential. Both sectors have performed solidly over 2021 but started 2022 on a very high note, especially UK banking names that thrive on an early Bank of England tightening cycle. The ECB should take notice giving the EU banking sector some hope for an H1 2023 policy rate normalisation back to ZIRP (zero-interest-rate-policy), saying goodbye to NIRP (negative- interest-rate-policy). Returning to US equity markets…one should be aware of the thin market breadth conditions that brought us to historic index highs.
Around mid-April 2021, 97% of stocks of the S&P 500 were trading above their 200-day moving average (MA) with S&P oscillating around 4200 points. By early December 2021 that number made a low at 54% of names rising towards about 74% by the end of 2021. Yet, the S&P 500 was making new highs topping 4796 points on January 3 last week. Market breadth runs extremely thin as fewer and fewer stocks were supporting the rally over the past year.
With a US FED policy rate hiking cycle upon us, the trajectory of real rates will be one of the factors that will determine the behaviour of US equity markets. Remember that implied equity and bond volatility measures tick above average at the start and at the end of rate hiking episodes.
So contrary to consensus, we should expect volatility to drop over time, not rise, as central banks forward guidance aligns with financial market expectations. Then again, confronted with fairly high levels of uncertainty, (confirmed by all 18 FED governors in last week’s minutes), the hiking path described above might be ‘a worst-case scenario’ for US bond markets. The minute they blink or hesitate in their resolve to hike over H2 2022 or 2023 the more attractive fixed income can become.