Economic Update
- While 2022 has been a year to forget, financial markets have been more optimistic about the prospect that peak inflation has been reached
- Fed Chair Powell acknowledged that a slowdown in the pace of rate hikes is likely at the December 14 meeting, but he expressed concern that an overheated labor market continues
- to fuel inflation in the services sector
- Fixed income markets appear poised to rebound in 2023 from the deeply negative returns of 2022
It has been a year to forget for financial markets, but as we approach the new year, there is growing optimism that the worst is finally behind us. If the Fed moves forward with what is widely expected to be a 50 basis point (bp) rate hike at the December 14 FOMC meeting, it would mark 425 bps of rate hikes in just 9 months, while also shrinking its bond portfolio since the beginning of June. Recent economic data, as a whole, have shown signs of slowing economic growth, but for investors, there are two important questions left unanswered: How high will the Fed ultimately take the fed funds rate, and how long will it stay at its terminal level? Following a strong Treasury rally on November 30 following a speech by Fed Chair Powell (more on that below), the bond market was priced for a 4.93% terminal rate following the May 2023 FOMC meeting and a 4.45% fed funds rate by the end of 2023. In other words, markets are pricing for 50 bps of additional hikes in the first half of next year followed by 50 bps of rate cuts in the second half of the year. Market participants are simply not buying the idea of ‘higher for longer’ at this point, whether prudent or not.
While Fed leaders have broadly acknowledged that a slowdown in the pace of hikes will likely be appropriate beginning at the next meeting, the notion of rate cuts in 2023 has not been mentioned as a consideration. Quite the opposite in fact. Nevertheless, financial markets remain ready to pounce on any hints of a Fed pivot, even if such an idea has been universally rejected by Fed leaders in recent weeks/months. They are fully aware that any such dovish signals, even if very subtle, would almost certainly spark a rally in bond yields and spreads that would work against the tightening of financial conditions they feel is necessary to combat inflation risks.
Powell Was Not Dovish
Jerome Powell scheduled a speech on November 30 to discuss the economic outlook and labor markets. Some have speculated that he scheduled this address ahead of the December 14 meeting to reduce policy uncertainty in the event that the central bank moves forward with slowing the pace of hikes to 50 bps, which he all but confirmed in his prepared remarks. Following his speech and Q&A session, 2-year to 10-year Treasury yields fell 12-17 bps in a dovish interpretation of the Fed chair’s remarks. However, there was nothing dovish about what Powell had to say. Instead, Powell expressed concern that inflation had spilled over from the prices of goods, which have been moderating thanks to easing of supply constraints, to non-shelter services. Shelter, or housing, inflation has been a major driver of core CPI in recent months and is expected to remain elevated in the coming months. However, Powell acknowledged what we have discussed in this commentary, the lagging effect of falling shelter costs passing through inflation gauges like CPI.
Powell then focused on the third source of inflation that he is more concerned with at this point – other core services – which he considers more correlated with wage growth and an overheated labor market. His concerns centered on the idea that labor demand is likely to exceed labor supply for some time due to multiple factors. Factors on the supply side included slowing population growth due to a drop in net immigration and excess deaths due to the pandemic, as well as a heightened rate of retirement during the pandemic. Given these labor market challenges, Powell concluded that “despite some promising developments, we have a long way to go in restoring price stability.” Additionally, he reiterated that “history cautions strongly against prematurely loosening policy,” something he and his colleagues have been emphasizing since September. Those conclusions feed the Fed’s guidance of higher for longer much more so than any dovish perception by market participants of a Fed pivot over the next several months.
Looking Ahead to 2023
Despite the uncertain path of Fed policy next year, investment-grade fixed income markets are poised for a much better year relative to 2022, which has been historic in regard to how deeply negative returns have been through the first eleven months. In last month’s commentary, we highlighted current opportunities in high credit quality bonds given the sharp rise in bond yields this year along with spreads now well wide of historic norms. Even if the Fed does have to keep the funds rate elevated for longer than the market is currently expecting, current carry in the bond market is as attractive as witnessed in the last 15 years, and for investors unable or unwilling to stomach prolonged interest rate volatility at elevated levels, hedged returns are also attractive on a proforma basis thanks to current spread levels. While the Fed and large banks remain on the sidelines, we are beginning to see improved demand from other investor bases in recent weeks, which contributed to spread tightening over the month of November. For example, the ICE BofA 30-year MBS Index outperformed duration-matched Treasuries by 1.5% in November, the most since such data was first published in 1997 thanks to tighter spreads and curve flattening. Of course, that performance was in the wake of a -1.53% net return versus Treasuries in September, the worst month on record, and current valuations remaining cheap to historical norms.
Rate volatility and liquidity, both of which are negatively correlated to one another, have been major themes in 2022. Sections of the bond market have shown signs of thawing over the last several weeks as markets speculate that peak inflation has been breached. That said, liquidity premiums remain high for most securities/sectors heading into year-end, presenting continued opportunities for investors with relatively low-cost funding.
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