The FED has lifted the anchor. On the website of the FED, you can find the definition of forward guidance as follows: “Forward guidance is a tool that central banks use to provide communication to the public about the likely future course of monetary policy. When central banks provide forward guidance, individuals and businesses will use this information in making decisions about spending and investments. Thus, forward guidance about future policy can influence financial and economic conditions today.” I invite you to read the above once more.
Listening to Jerome Powel and a host of other voting and non-voting FED governors this week, one can only conclude that forward guidance has been put on a backburner. The sell-off in US rates over the past week was disorderly. It was disorderly, as the public started second-guessing the possible shape of the FED’s reaction function over 2022 and 2023. The market is pricing in May and June policy rate hikes of 50bp instead of 25bp increments. Alternating between 25bp, 50bp or even 75bp in a policy rate hiking cycle creates unintended consequences. It is not conducive to sound decision making about spending and investments. If anything, this FED style communication has a bad influence on financial and economic conditions today. Bond volatility conditions resemble pre-GFC times and sit at double the level that we got accustomed to between 2015 and 2020.
Since making a low print on the US 10-year rate at 1.17% back in August 2021, this key rate indicator has moved up 1.30%, settling at 2.47% on Friday. The nominal US Treasury yield curve 1-year forward is inverted with 2-year rates priced end of March 2023 at 2.96%, the 5-year rate 1-year forward at 2.75% and the 10-year rate 1-year forward at 2.64%. Reading a pending recession into this phenomenon is premature. When we look at the real US yield curve 1-year forward we notice a positive slope with 2-year real rates 1-year forward at -0.43% and 10-year real rate 1-year forward at 0.00%.
Comparing the nominal and real US yield curve in forward space makes for an interesting read, as we discover an expected average inflation of 3.4% between March 2023 and March 2025. At the 10-year point we still price in average inflation over 10 years of about 2.64% in March 2023. Fixed income markets will face a challenging set of conditions over 2022 and 2023.
The silver lining of this bond bear market is that the chapter discussing the amount of outstanding negative yielding bonds is ending. The German yield curve has surfaced into positive territory as of their 3-year maturity and longer. The German 10-year Bund rate followed a similar path to its US twin and moved from -0.50% in August 2021 towards almost 0.60% on March 25.
So apparently, gradualism is off the table. Gradualism, together with forward guidance, was the preferred approach to tackling a slowing or heating of the business cycle. Confronted with unanchoring inflation as a result from pandemic and geopolitical conflict, central banks have decided that they have to seek an equilibrium through a series of spurts. A spurt in policy rate normalisation next to a spurt in balance sheet run-off: delivering a punctuated equilibrium: a notion that exists in biology describing accelerations in the evolution of species.
The market has to adapt to these changes in central bank winds. Tailwinds have been omnipresent over the past decade. The current headwind could be around over 2022 and 2023. For 2024, markets pencil in accommodation. But that is an awfully long time in markets that allow for limited visibility. Diversification and quality security selection across fixed income sectors are necessary to weather the storm. Will higher yields on offer today already make the journey sufficiently attractive? Delivering real capital appreciation over 5 to 7 years comes closer, but only under a path that sees the inflation trend back to its target of 2%. Another inning to the upside might start to attract investors whose confidence has been shaken into bond markets.
