The Fed and inflation
“Never bet against the Fed”Is the mantra that continues to circulate from global financial crisis. In the wake of the press conference held in January by the president of the Federal Reserve, Powellwe analyze in this comment the possibility of the Central Bank to defeat the next opponent: rampant inflation.
Fundamental
In the January press conference, the Federal Reserve (Fed) has launched a more restrictive message than expected. Inflation is high and the Fed will intervene. President Powell left open the possibility of in raise rates to a greater extent and in a shorter time frame and, at the same time, to reduce the enormous budget that the central institution has accumulated during the pandemic.
It seems that the Fed are considering all options for a tightening of monetary policy. The reason for this more restrictive stance is rampant inflation, but the Fed it will need the support of the economy to solve this dilemma.
The the labor market is solid and wages continue to rise compared to a shortage of manpower which seems destined to continue. There still is disruption in the production chains and this helps to accentuate the inflationary pressures. It could be argued that the Fed has been late in identifying his latest opponent which, however, the market had noticed months ago.
Also the Financial Conditions Index – which integrates stock market movements, credit spreads, yield curves and changes in the dollar – signals a crackdown on the ultra-accommodative financial conditions in place since the start of the pandemic. However, based on the first published company financial statements, the American companies are in excellent health, with low levels of debt and growing profits.
Quantitative assessments
After the Fed press conference, the market started to discount five increases of 25 basis points (pb) in 2022 and the quantitative tightening (QT) process is expected to begin in the summer, likely inducing a flattening of the yield curve.
After the recently fluctuating trend in risk assets, the lack of clarity of the Fed the stance it intends to adopt is frowned upon by the markets and does not reassure them.
US equities have fallen from their highs and spreads on Investment Grade and High Yield bonds have widened the largest since the discovery of Omicron variant, with a spread with respect to the 5-year CDX index equal, in order, to 60 bps and 340 bps.
In addition, the 2-10 year segment of the US yield curve flattened to below 80bps, the lowest since 2020. This is an important recessive indicator that the Fed can look to to improve market conditions.
Technical factors
According to our proprietary investigations, Fr.Positioning indicates that the market has a strong exposure to short duration.
This figure is also confirmed by the positions in futures, a logical consequence of the hypothesis, which has strengthened in recent months, of an increase in rates by the Fed. This expectation was also shared by US firms which, in January, attempted to anticipate the potential rise in the cost of money by issuing USD 147 billion of debt.
As the Fed raises rates, US companies could likely place 65% of annual issues in the first half of 2022compared to a historical average of 55% of total debt issued in the first six months of the year in the period between 2012 and 2019.
What does this mean for bond investors?
With the expected rate hikes and tightening monetary conditions in the near future, it is beneficial for investors to maintain a short duration in bond portfolios. It is also important to remember that the Fed is not alone in this, as other Central Banks of Developed Markets – for example the Bank of England, the Bank of Canada and the Reserve Bank of Australia – are planning several rate hikes in 2022.
In the immediate future, with the fluctuating trend of the riskiest markets, it will be inevitable adopt a selective approach in defining the asset allocation for the credit sectors. Given the widening of spreads observed in January, investors should be aware that a shift in the Fed’s bias in support of the markets could produce an improvement in the risk picture, with repercussions on bond lists.
However, investors also need to continue to keep an eye on the extreme risks that could arise from the escalation of tensions between Russia and Ukraine. Let’s not forget, ultimately, that the Fed wants prolonging not destroying the economic cycle.
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