FOMC: Hard to shake sense the Fed is behind the curve

Jerome Powell’s recent testimony to the Senate Banking Committee, in which he said the Fed would discuss a faster taper of its asset purchases at December’s FOMC meeting, has led to intense speculation that we could see a move this week. A doubling of the current reduction to $30bn per month has been mooted, and we think committee members arguing in favor will certainly have plenty of ammunition in the shape of recent employment and inflation data. US job openings surged back above 11 million in October and annual CPI jumped again to 6.8% in November, its seventh consecutive monthly reading above 5%; it is little wonder Powell sought to “retire” the word ‘transitory’ in that same testimony on November 30.

A ramp up in tapering to $30bn would bring forward the end of asset purchases from June 2022 to around March, and we wouldn’t be surprised to see the Fed make that move on Wednesday. The data continues to tick a lot of boxes for tighter policy, and we think the Fed will value the flexibility to hike earlier if it deems that necessary. The market is currently discounting a first rate hike in June, but a faster taper would likely bring that expectation forward. As for the meeting itself, investors will be looking for any significant changes to the Fed’s dot plots, as well as any changes in its growth and inflation projections. At the bare minimum, we expect an accelerated taper and median dot forecasts to be somewhat higher than previous.

What could this mean for the markets? In Treasuries, the 2s-10s curve has in fact already flattened from around 100bp before Powell’s testimony to around 80bp today, with the market now moving towards pricing in three hikes from the Fed in 2022, so you could argue an earlier taper and hike is already being priced in. Powell’s comment about retiring the word transitory was widely interpreted as a hawkish shift, and in some quarters even the early stages of a ‘Powell pivot’ towards a more aggressive tightening cycle, so we initially saw credit spreads widen, not just in US markets but globally. However, we cannot ignore the emergence of the Omicron variant of COVID-19 as a factor in this. In fact, with recent headlines suggesting Omicron is potentially more contagious but less life threatening, and preliminary data suggesting vaccine booster shots are effective against it, we have seen a sharp rebound in spreads back towards previous levels.

If we look ahead to 2022, we think one of the biggest risks facing investors next year is central banks getting caught behind the curve. An acceleration from the Fed this week would clearly go some way to addressing that risk, but for some time now the data has been pointing to a strong and increasingly broad economic recovery in the US, and yet the Fed will enter 2022 with rock-bottom rates and asset purchases still in the tens of billions. The sense that the Fed is behind the curve will be a difficult one to shift. It is of course very difficult to predict where rates will get to over the course of 2022, but the direction of travel is clearly for them to be higher and though government curves have flattened meaningfully in the past couple of weeks, a lot will be determined by central bank messaging over the next few meetings.

Fortunately for investors, we believe credit fundamentals remain solid. Default rates in the US and Europe are extremely low, and strong corporate earnings should continue to provide positive momentum across most asset classes. We continue to like the banking sector and specifically Additional Tier 1s (AT1s), which are one of our top picks for 2022. In our view, banks have led the recovery and proven their resilience through the pandemic, while strengthening their balance sheets. Banks are also generally more immune to rising inflation than most industries and tend to benefit from a rising rate environment. Next, we think European collateralised loan obligations (CLOs) represent one of the best value opportunities across global fixed income at the moment. Not only do we think the yields on offer here look attractive, but credit fundamentals should bolster performance and as floating rate assets, CLOs should also benefit from a rising rate environment. Finally, another sector that looks attractive to us is European high yield, especially given the relative stability of its underlying rates market (German Bunds). We expect US assets to experience a decent amount of Treasuries-related volatility in 2022, whereas ECB policy and guidance is such that European rates look better anchored and should provide a better base for credit exposure. 

From an asset allocation perspective, the heightened rate volatility we expect in 2022 would steer us away from long end rates and choosing to hold short end rates for liquidity purposes only. In our view, a positive approach in credit will be to keep duration relatively short, but with enough higher yielding assets to help support portfolios against rate risk. Periods of spread widening in 2021 have proven a good opportunity to add to favored credits – the weakness of the past couple of weeks being a prime example – and we expect more intra-cycle dips to present buying opportunities over the course of 2022.