Mini Budget, Maxi Vol: Stay Cautious in the Front End of the Curve
The US Federal Reserve (Fed) remained hawkish at its last meeting, hiking as expected by 75bps. Despite the wild swings in many bond markets on the back of the UK turmoil, inflation pressures remain. GDP was revised upward in the US and Core PCE readings were firmer than expected. Meanwhile, a weaker GBP, large moves across the curve, and a Euro HICP print at 9.5% all point toward more tightening and volatility in bond markets. Higher yields and low rate sensitivity in the front end may be the new alternative. TINA is dead; short-dated bonds could be an alternative.
The Fed, other central banks, and the rate cycle
As expressed in a previous Strategy Espresso, we continue to believe we are still in the first stage of a three-pronged policy cycle that could be summarised as follows: upside surprises on inflation still fuel the debate on 50bps versus 75bps hikes and focus on inflation. It could be called, “raise at all costs.” For now, the lagged effects of policy tightening are slow to appear, even if some signs of weakening inflation start to appear in certain numbers.
Once peak inflation is past (hoping it’s a when and not an if), phase two will show a Fed more sensitive to signs of a slowing economy; however, it may be too early to call for the end of the policy cycle until it decelerates toward the 2% target. Indeed, if Non-Farm Payroll numbers this week are expected to slow (surveys point to 250k versus 315k in early September), as well as average hourly earnings ticking down 0.1% from 5.2% to 5.1%, this still paints a tight market forcing the Fed to stay on an aggressive tightening path.
The last part of the cycle is when rate hikes are fully complete. Based on current market expectations we are still 100-125bps away from this. Meanwhile, the Bank of England and the European Central Bank still have 375bps and 225bps of tightening to do, respectively, over the next year (based on the difference between the current rate and the one-year forward). The next move will depend on how aggressive the Fed has been and how painful it is for the economy. And the risks appear skewed to the downside. Volatility could break balanced models and generate further situations like the mini budget in the UK, while also reducing the willingness of politicians to counterbalance monetary tightening with fiscal promises without a clear funding strategy.
Figure 1: Market Implied 1-Year Policy Rate Move (%)
No duration – no performance…pain!
Most segments of the bond market have posted negative returns in local currency terms in 2022, except T-Bills (+0.63% in USD terms) and Chinese government bonds (+3.03% in CNY terms).1 While many of the hikes are already well in the price (see Figure 1), inflation keeps surprising to the upside and the strong real dollar puts pressure on other markets. Performance during the past month is clearly a reminder of the drivers of fixed income instruments: duration and spread. Staying in the short end can help alleviate big performance swings; for example, 0-3 year corporate investment grade indices fell around 1% to 1.2% in September.
Figure 2: Yield and Duration for Investment Grade Corporate Indices
Duration rules – less sensitivity without losing too much yield
Hawkish rhetoric is doing its job of containing inflation expectations and, with the significant amounts of tightening that have already been delivered still to feed through into the economy, the turn in the rate cycle could occur quite quickly. Short-duration government and investment grade corporate funds would give investors some exposure to the turn in the rates cycle when it does occur (unlike cash).
Front-end valuations have already been hit hard and the front end of the curve already prices a significant degree of tightening. If this tightening proves overly aggressive, then there will be scope for the front end of the curve to rally. Given the wild ride that markets have undergone in the past few weeks, it may take a moderating of inflation pressures and of central bank rhetoric before market participants have the courage to take on meaningful amounts of duration risk.
Figure 3: Yield and Duration for Investment Grade Corporate Indices
How to play the theme
Investors looking to implement the themes described above can do so with SPDR ETFs. To learn more about these ETFs, and to view full performance histories, please click on the links below to visit the fund pages.