From the Desk of the CIO – Fixed Income
Risks abound in an environment of stronger than expected inflation and a pivot in US monetary policy further complicated by a divisive political climate, arguing for prudence and lower risk.
I distinctly remember US President Trump voicing disapproval of US monetary policy at various points in his presidency prior to COVID. The narrative was clear and the criticism stark: President Obama benefited from accommodative, near-zero interest rate policies while the Trump administration was forced to deal with rising interest rate policy. Scant mention was made of large tax cuts and the benefits of material deficit spending. Instead, the refrain was that US Federal Reserve Chair Powell was thwarting Trump’s attempts to grow the economy by counteracting fiscal expansion with tighter monetary policy.
Fast forward to January 2022.
During a marathon press conference, President Biden detailed the economic consequences of the virus, challenges that include global supply chain disruptions, inventory shortages, strengthening (stretched) labor markets and rapid inflationary pressure around the world. Biden felt compelled to remind us of the Fed’s support for the post-COVID economy while also mentioning Chair Powell’s responsibility for ensuring that inflationary pressures don’t become entrenched. In doing so, Biden was weighing into the debate on recalibrating monetary policy.
The prior paragraphs simplify complex problems. That said, it’s nearly impossible to not come away with the sense that monetary policy is falling prey to political influences, and importantly, that both sides of the political spectrum are comfortable wielding influence in this arena. In the simplest sense, is it not human nature to (at least) listen to one’s boss? Is there not a basic behavioral tendency to consider the opinion of the administration that appointed you as a policymaker?
Should we care? More important, does it matter?
The Fed’s independence is widely recognized as a foundational tenet of effective monetary policy. In the current sociopolitical environment in the US, however, everything is fair game to be politicized. Is the question of whether the Fed is succumbing to undue political influence really misplaced? Is it not worth considering in the context of investment implications?
Various hot topics such as wealth inequality and climate change have already surfaced as considerations for central banks. Subjects of this nature can clearly become political in nature. The truth is these issues are difficult to address through monetary policy — and many believe they are outside the scope of monetary policy mandates.
The current economic situation in the United States raises another challenge in this context. Inflation continues to run much higher than the Fed’s expectations and appears more persistent and longer term in nature than previous projections of transitory inflation. Inflationary pressures on necessities such as gas and heating oil run the risk of crowding out consumer spending, especially when wages don’t keep up. Higher prices and supply dynamics also create growth challenges. In other words, inflation could have a deleterious impact on economic growth.
Macroeconomic concerns are challenging enough for central bankers without the added complication of an inflation narrative in a fractious political environment. Inflation is likely to become a heated point of discussion in the period leading up to the midterm elections in November, hence the concern evident in President Biden’s recent commentary. Some might see it simply as political spin and an effort to deflect responsibility; a more sinister view might read the commentary as a call to action to control inflation.
Monetary policy pivot
Regardless of the causes of inflation and discussions about potential solutions, the implications for investors should not be ignored. The Fed has clearly shifted its stance and messaging about monetary policy over the past few months. Once viewed as patient and deliberate, and often criticized as being behind the curve, the Fed has now pivoted to an aggressive stance against inflation, with the full toolkit of interest rate policy and balance sheet at its disposal.
Markets have responded accordingly: higher front-end interest rates, futures pricing (and commentary) indicative of more aggressive Fed hikes, real interest rates finally moving off historic lows and equity volatility indicative of a monetary policy inflection point. Against this backdrop, a flattening yield curve is also evident, possibly signaling a traditional Fed-induced end of the economic cycle.
Taken together, these indicators point to tighter monetary conditions. The Fed needs to tighten to have a chance of containing inflation. Equity volatility and higher interest rates are starting the tightening process for the Fed, but actual indicators of financial conditions have been slower to respond. Why?
The underlying answer lies with credit spreads. The pricing and availability of credit is a major factor in financial conditions. As of this writing, risk markets in the fixed income marketplace have been slower to respond to the Fed pivot than expected. New deal flow is off its recent high levels, but the market remains open. Event-specific news drives idiosyncratic credit stories, but most credit indices remain only slightly wider than recent tight levels. Liquidity ebbs and flows based on the inventory level of any given counterparty, but it still feels far from constrained.
Will the center hold?
Something needs to give, as the various markets mentioned here appear to tell different stories. It could be that fixed income risk markets are indicative of underlying strength and continued confidence in macroeconomic conditions as well as confidence in the Fed’s ability to navigate a soft landing. On the other hand, spread markets in fixed income may well fall prey to the Fed’s more aggressive reaction function to inflation and represent the next step toward tighter conditions.
This issue is complex and hard to adequately address in a brief note. That said, inflection points in monetary policy and the challenging impact of stronger-than-expected inflation are pervasive risks in today’s marketplace. This is particularly true when viewed through the lens of both macroeconomic fundamentals and political pressure. When combined with aggressive valuation levels still prevalent in today’s interest rate and spread markets, the environment appears to warrant prudence and less aggressive risk taking.