Fed Outlook: Macro trumps tapering

Volatility is likely to be ahead of us in global bond markets as the possibility of tapering looms at the next U.S. Federal Reserve meeting in early November. However, any yield rise will turn out to be just a blip in a larger downward trend in yields that is driven by powerful structural forces like digitalization and demographics.

All eyes are currently on the Fed but in the greater scheme of things tapering won’t be the catalyst for a real change in direction of yields. History is a case in point: In the middle of 2013, rates backed up 100 basis points (bps) when the Fed uttered the “T”-word for the first time indicating their intention of weaning markets from lavish liquidity supply after the Global Financial Crisis (GFC). When they finally did start tapering in December 2013, rates actually rallied. It wasn’t until three years later that the Fed started quantitative tightening which pushed rates 70 bps higher.

Growth and inflation drive outlook on rates

These aren’t massive moves, especially compared to the beginning of this year when the reflation trade kicked in and rates sold off 120 bps. This proves that bond markets do not simply depend on the ratio of government supply versus central bank demand. Ultimately, yield outlooks depend on the future trajectories of growth and inflation. Recently, stagflation fears have reached record levels warning of a return to the 70s. In my opinion, these concerns don’t take into account that there are quite a few significant differences between then and now: first of all, today, we are in a growth period but can't supply enough and, second, unemployment is actually the lowest (4.8)% since the COVID-highs (14.7%) while in the mid-70s it reached 8.2%. And let's not forget that there are forces at work that can trigger a healthy economic rebalancing and help supply chains ease before stagflation digs in its heels. In fact, demand is likely to level off due to consumers scaling back because of rising prices before growth gets killed by inflation.

So, there is a high likelihood that growth will stay low in the long run, while inflation will turn out to be transitory, not least because megatrends such as digitalization, globalization and population growth have been keeping both of them in check already for quite a while. Ultimately, macroeconomics override the tapering talk. This means that as long as inflation and growth expectations stay low, yields will have a hard time getting off the ground.

Big rate moves are the bread and butter of any active bond manager

This is not to say that smaller moves in rates are irrelevant. In fact, they represent short-term tactical opportunities for active bond managers. However, it gets much more interesting when the Fed makes actual moves on rates. And clearing the decks for rates hikes by removing asset purchases is a necessary step in the process. So, tapering could be a precursor for rate moves by the Fed, should inflation and unemployment make substantial progress. Looking at current sentiment, I would say that rate hikes are possible from mid-2022 onwards - provided tapering starts as early as November this year.

Even if this scenario came true, this would hardly be the end of the bond market (as many critics have said). Instead, it would result in yield and spread moves that are the bread and butter of any active bond manager. When the Fed makes big moves on rates, the correlation between yields and spreads goes to 1. This is because the short end of the US yield curve reacts first by moving higher triggering a sell-off in risk markets resulting in spreads widening. So, yields and spreads go up together. Once risk is up, investors flock back to safety setting off a rally in government bond yields which spills over into spread markets, albeit with a lag. Therefore, bond markets have a built-in stabilizer effect where markets move through a natural cycle of yield and spread moves. During this time, a bond's total return receives varying contributions from its duration and spread components that an active bond manager can take advantage of via long and short positions on the relevant return drivers.

Spread products provide alpha in low yield environment

Regardless of whether and when we can expect tapering, rates are unlikely to digress from their inexorable downward path in the long run.  Depending on where you think the floor is on rates, bondholders can benefit from decent rallies. When Covid hit, investors were thankful for the low-yielding govies in their portfolios as rates fell from 190 to 50 bps posting double-digit returns in capital gains. But even aside from these sudden bouts of volatility, alpha sources can be found in spread products that offer yield pick-up over risk-free rates in low-yield environments. This is because spread products have the characteristic that perceived risk tends to be higher than actual risk – a market inefficiency that active bond investors can exploit.