As expectations of a Fed pivot fade, what’s next for fixed income?
Fed Chairman Jerome Powell’s hawkish tone after the Fed’s latest meeting signals that interest rates could stay higher for longer. Greg Bonnell speaks with Scott Colbourne, Managing Director, Active Fixed Income Management at TD Asset Management, about the potential implications for the bond market.
Greg Bonnell: Of course, the markets tried to take some time to figure out what exactly we got from Fed Chairman Jerome Powell yesterday afternoon. We are now, unfortunately, down as a result of all of this. Investors, at least some of them, think there may not be a pivot any time soon. Let’s introduce Scott Colburn, Managing Director, Active Fixed Income Management at TD Asset Management. Scott, let’s try to summarize what happened. It was a wild afternoon yesterday afternoon, of course.
Scott Colburn: Very wild, yes.
Greg Bonnell: We seem to have reached a market consensus on what we got from Jerome Powell. what was that?
Scott Colburn: The statement was fundamentally clear, that rates still need to rise, but the recognition that monetary policy works with lags, and there is a cumulative effect on the economy of those lags. And so, at the initial market reaction, it was kind of a positive reaction, because we had hoped for some sort of recognition of a pivot or a slowing in the pace of rate hikes. The press conference with Governor Powell kind of chilled everything. And basically he phrased it in three ways. He said, look, we have to think about the rhythm first. And we recognize that the pace has been very fast. And this rhythm will change in the future. And we’ve seen that in other central banks, the Bank of Canada, as you just mentioned. So the pace will definitely slow down. But it emphasizes the destination, the end of it, where in our world, the bond world, it’s called the terminal rate. And where is this rate? And he acknowledged that since September, the last time we had an update to their forecast, it’s higher than then, which was around 4.5%, 4.75% . So we’re going to have a higher terminal rate, and we’re not exactly sure. And so that dampened market expectations. And certainly, the duration of this type of crunch cycle will be longer. And the combination of the last two of these points, the higher terminal rate and the duration thereof, is holding markets back. And bonds went up, flattened the curve. Thus, short rates increased more than long rates, and this certainly had a dampening effect on the equity market.
Greg Bonnell: It was interesting, as you said, the statement. And the statement gave you this little clue, as we got from the Bank of Canada. Hey, we’ve done a lot, and maybe we need to reflect on what we’ve done. But then, like you said at the press conference, it looked like the Jerome Powell we had in Jackson Hole.
Scott Colburn: Exactly.
Greg Bonnell: You walk into this event thinking, oh, he’s probably going to tell us. Do not worry. We’ll calm down, and we won’t cause too much pain, and just very severe. If there was one word that came to mind, it just seemed like he was on this stern path.
Scott Colburn: And he recognized, if you look back in history, the mistake is to be premature in moving, in pivoting, in cutting, in pausing. This is the lesson of history, is that we must not be premature on this subject. If anything, he’s going to err on the side of over-tightening, and– rather than under-tightening. And so that’s definitely a harsh message.
Greg Bonnell: So that probably takes us through the end of this year and into 2023. You talked about the end point and the length of the suspension around that end point. And as you said, President Powell, indicating… we didn’t get a new dot chart, did we?
Scott Colburn: No.
Greg Bonnell: It didn’t come this —
Scott Colburn: December.Greg Bonnell: –time around. So that seems like a hint that when we finally get to where we want to be, it might be higher than you previously thought. And we will stay there for a while. What does this do to the markets?
Scott Colburn: Well, from a bond investor’s perspective, that means we continue to have pressure on the beginning of the yield curve, and short rates are rising more than long end rates, flattening the curve rates, and in general, all higher rates. So we will continue to see bond yields rise. And the destination, now we have a lot of speculation. Where is the Fed funds rate headed? It is now 3.75% to 4%. Is the destination 5%, is it 5.75%, is it 5.5%? So I think it’s probably 5%, 5.25% that’s where I would land. But we’ve seen the US domestic economy, particularly consumption, the job market, remain resilient. So we’re going to start… we’re in a data-driven world. They clearly pointed that out. And we will have new data tomorrow, Friday.
Greg Bonnell: It looks like some sort of loop, right?
Scott Colburn: Yeah. So we will get the jobs data. Maybe the pace of job growth is slow, but it’s still solid. The Fed acknowledged this yesterday. They said, look, things haven’t really picked up on the labor side, and it’s too strong to even start this pivot process. So we’ll see that. We will see the CPI next week. So there’s definitely an element of data dependency to that. But I think we have a long way to go.
Greg Bonnell: When it came to– you mentioned the fact that– and Jerome Powell also said this– that the labor market is still strong and it’s still tight. When it comes to inflation, do we feel that central banks are starting to win this fight, even just – maybe not even winning it, but putting the brakes on it?
Scott Colburn: Yeah. I mean, when we started discussing over-collateralization and overshooting inflation, it was the COVID shocks. It was supply chains. It was inflation and energy shocks. And that is definitely fading away. We have certainly seen a turning point on this side. We see evidence that the rate of increase in the overall CPI is declining. All of this therefore works in favor of lower inflation next year. And when you look at the details of the bond market, it clearly shows that inflation is falling. Headline inflation is closer to 3% in the second and third quarters of next year. That being said, the core, the labor market, the sticky part of core inflation is the challenge. And so, from the perspective of the central bank, particularly the Fed, they have a way to – more ways to reduce demand here, to balance out the imbalance of supply and demand in the economy.
Greg Bonnell: Before leaving the central bank discussion, the Fed is obviously very important – not the only central bank in the world. We heard from the Bank of England today, didn’t we? And that doesn’t sound like good news to me.
Scott Colburn: Listen, they raised rates by 75 basis points. But they’ve pushed back a bit on how far rates are going to go. So it was a bit of a surprise to the market in the sense that Governor Bailey said, listen, we’ll see – if we follow what’s set in the market and the path that’s set in the market – that we’ We will see a sustained period of recessionary growth. And I think that surprised the market a bit. But there is certainly room to continue to see higher rates. I think that’s the challenge for all central banks. The Bank of Canada recognized it, the Bank of England today, recognition. We are entering a low growth environment, is it in recession? How deep is a recession next year in 2023? And that has implications, obviously, for bond markets, stock markets, credit markets. And not all economies will be aligned as we did last year. We’re going to start to see that differentiation emerge.