Today’s CIO Weekly Perspectives comes from guest contributor Olumide Owolabi.
Three weeks ago, in CIO Weekly Perspectives, Brad Tank highlighted the hawkish tilt at the June Federal Open Market Committee (FOMC) meeting.
Since then, U.S. Treasury yields have, surprisingly, been on a daily trend lower. Acute curve-flattening has left a puzzled investor base searching for answers.
Is the Federal Reserve’s hawkish tilt a policy mistake? Is U.S. growth slowing rapidly, and could the reflation trend be over this early in the cycle? Has the market been caught offside with its short-duration positioning? This is no doubt an inexhaustive list—but these are some of the most frequently asked questions.
Fed Policy Mistake
It was evident in the tone of the June meeting that the FOMC was worried about the level and pace of inflation and the possibility of losing its credibility as the “inflation fighter.”
It was also evident that the inflation story prompted a conversation about asset-purchase tapering and a shift forward in the FOMC’s rate-hike expectations, compared with previous communications and investor expectations. The swift change of position has led investors to question the Fed’s commitment to its new Average Inflation Targeting framework.
However, the June meeting minutes released last week seem to minimize the importance of the dots, while messaging a less aggressive taper announcement than previously believed. Overall, the minutes imply a reaction function that remains unchanged.
The discernible difference in sentiment between the meeting date and the minutes paints a picture of an FOMC trying to hedge its bets by getting ready to act if inflation proves to be more than transitory, but signaling that it remains comfortable with its accommodative policy stance should inflation normalize within a tighter range and in line with its previous expectations.
Without a doubt, the lack of clarity around the Fed’s message and the ambiguity around the guideposts for implementing the new framework create uncertainty when it comes to estimating the Fed’s reaction function and the long-run neutral rate. We don’t think anything has fundamentally changed in terms of monetary policy expectations, however, as the timing of rates liftoff and tapering remains the same as communicated after the June meeting.
In short, our view is that the “policy mistake” narrative has more to do with a baffled investor base rationalizing a story to fit the surprising recent yield movements.
Slowing U.S. Growth
Concerns about slower-trending U.S. growth seem to be replacing the inflation worries of the second quarter. We think these concerns are unfounded as the economy remains firmly in an expansionary phase, driven by robust consumer spending supported by continued fiscal transfers.
Even if growth is slowing, it’s from an extremely high and unsustainable level to a level that is still significantly above trend. We expect the path of growth and inflation to trend lower as fiscal support fades—but the idea that we might revert to December 2020 growth and inflation expectations with February 2021 levels of yield seems extreme.
We are witnessing a market trying to establish an appropriate response to a volatile stream of fundamental data. But, again, we don’t think this is a viable reason for recent price action.
Instead, to us it seems that a combination of technical factors has come together at the same time to provide the proverbial “perfect storm.”
First, market positioning reveals that investors remain bearish on duration despite decent-sized short-covering after the June FOMC meeting. Rallies in rates have been persistent, while sell-offs have quickly faded.
Second, fears are increasing that the Delta variant of COVID-19 could delay global reopening and decay growth expectations, leading investors to readjust their positioning to prepare for a risk-off event.
Lastly, a sudden spike in geopolitical volatility caused by the recent breakdown of OPEC supply negotiations and news of China’s crackdown on tech firms has provided another reason to hedge portfolio risk.
We think all these have combined to exacerbate the demand for duration during a light summer trading month.
To sum up, we believe that the recent shift lower in yields is mostly driven by technicals. There is potential for more in the near term, but after a persistent rally over the last eight trading sessions, we think we are getting to an inflection point where the investor base is likely to reassess the path forward—and either acknowledge that we are in overbought territory or find more reasons to push rates further down.
Regardless of the near-term path of bond yields, we still believe that interest rate volatility is likely to rise over the rest of the year. As articulated in our Fixed Income Investment Outlook for Q3 2021, we expect wider ranges in rates and credit spreads as monetary policy transition takes hold.
In Case You Missed It
- ISM Non-Manufacturing Index: -3.9 to 60.1 in June
- U.S. Initial Jobless Claims: +373,000 for the week ending July 3
What to Watch For
- Tuesday, July 13:
- U.S. Consumer Price Index
- Wednesday July 14:
- U.S. Producer Price Index
- China 2Q 2021 GSP
- Thursday July 15:
- U.S. Initial Jobless Claims
- Bank of Japan Policy Rate Decision
- Friday July 16:
- U.S. Retail Sales