Reasons to be constructive on extension risk
The US Federal Reserve chair, Jerome Powell, spoke at the Brookings Institute in Washington on Wednesday and again highlighted the central bank’s intention to slow down its extraordinary pace of rate hikes to 50bp at the upcoming December meeting, while also reiterating the likelihood of a higher terminal rate than estimated in September, when the ‘dot plots’ pointed to a 4.5-4.75% Fed Funds peak next year.
This is all as expected, yet the market rallied strongly after the statement on Powell’s acknowledgement that there has been some sign of inflation starting to soften, and that he is still hopeful of a soft landing, where the US economy grows below potential for a period of time but misses a recession.
Given the Fed’s need to keep financial conditions tight and policy highly restrictive, we imagine the sharp rally in equities (Nasdaq +4.4%) and bonds (10-year USTs -17bp) yesterday was largely unwelcome, and Powell now has to balance the fine line between signalling a slower pace of hikes and making sure the market does not construe this is a pivot. He again pointed to the fact that the timing of this moderation is less significant than the question of how high rates will have to go and how long they will stay there for, saying that restoring price stability will likely require holding policy at a restrictive level for “some time”.
Yet short term interest rate swaps are pricing in almost two cuts in the second half of 2023, betting that a slowdown in growth (potentially even a recession) and lower inflation will allow the Fed room to ease after this year’s historically sharp tightening.
While we think the market might be moving too quickly to price in cuts, it is worth noting that there are tentative signs that the 375bp of hikes the Fed has already put through this year are starting to make a difference, as we wrote a few weeks ago.
Aside from the significant cooling off in the housing market (an inevitable impact of 30-year mortgage rates topping 7%), goods inflation is normalising from very elevated post-pandemic levels, with some components now showing deflation (Apparel and Used Cars, for example). Housing, while still at elevated levels, has seen a significant fall in the inflation rate of new leases over the past six months, from +18-20% to mid-to-high single digits, with further falls expected into 2023.
Ultimately though, Powell pointed to the labour market as the most important driver for inflation from here. Non-housing services inflation, which covers a wide range of services from “healthcare and education to haircuts and hospitality”, accounts for more than 50% of the Fed’s preferred core PCE index, and wages make up the largest cost in providing these services. The balance between labour demand and supply still remains skewed, with 4m job openings over and above the number of unemployed that are looking for jobs, but this number has started to ease recently, with “Jolts” job openings reducing by 1.5m from the peak in March. We have the monthly non-farm payrolls (NFPs) report tomorrow, which will be keenly watched by the Fed (and the market); consensus is currently for payroll growth of 200k, still high, but slowing from the 290k three-month average (which was itself relative to a 450k average for the first seven months of the year).
So, the Fed has not won the war on inflation by any means, but we believe the trend over the next 6-12 months will continue to show a decline in the inflationary pressures seen post-pandemic. When inflation rolls over is ultimately less important than where it ends up, so the Fed will remain highly data-dependent, and will most likely want to make sure the market does not get ‘ahead of itself’. With elevated levels of cash sitting on the side-lines and attractive all-in yields, we can see why the market move tighter has been persistent over the recent period, and we think this has been an opportunity to selectively move up in quality and rotate into some attractive deals in the primary market, while maintaining significant liquidity buffers.