Source: AFP
Source: AFP
Powell’s Jackson Hole message exceeds even hawkish expectations
Federal Reserve (Fed) Chairman Powell delivered a concise, forceful and unequivocally hawkish view, dispelling any remaining market expectations of an early end to rate hikes or even a rate cut. Powell commented that “restoring price stability will take some time” and will result in “a sustained period of below trend growth” and “pain to households and businesses.” It does not require much of a leap to the logical conclusion that the Fed is willing to tolerate a hard landing or even recession to restore price stability, which the central bank considers the “bedrock of the economy.”
In response to Powell’s hawkish oration, risk assets sold off substantially (US equities were down -3%) and the safe haven USD strengthened. US Treasuries sold off, with the short end of the curve bearing the brunt of the pain; the two-year US Treasury reached its highest yield since 2007.
Further US Treasury Curve flattening likely
We believe that the Fed’s renewed zeal to bring about price stability/lower inflation, even at the expense of economic growth will result in a higher for longer restrictive policy. In fact, while fed funds has now reached neutral, longer-run levels around 2.50% we believe that the Fed wants to keep pushing interest rates into restrictive territory – we think as high as 4.00% – to curb inflation
Source: Bloomberg
This can clearly be seen in the chart below, where consensus forecast is that the fed funds rate will reach 3.90% by March 2023 and stay there into mid-year before starting to subside. This is decidedly less dovish than the prevailing consensus in mid-July.
Source: Bloomberg
Long end likely to be more anchored going forward
As the chart below shows, US Treasury curves have flattened in the past month; we expect this trend to continue in the coming months. Powell’s unambiguous comment that the Fed will reduce inflation “even if it results in a sustained period of below-trend growth and softness in the labour market” will likely cap longer maturity US Treasury yields given the likelihood of a severe economic contraction or recession. Conversely, shorter-term US Treasury yields, i.e. the two-year, are more closely tied to the Fed’s activist, higher for longer policy. In fact, short-end yields could end up over-shooting should the Fed decide that 4.00% is inadequate.
Source: Bloomberg
Conclusion
Fed Chairman Powell’s forceful, unambiguous and unequivocally hawkish remarks at Jackson Hole compel us to revise our previous barbell strategy. We believe that the Fed’s rate hikes toward 4.00% coupled with quantitative tightening will result in rising yields in short-dated US Treasury securities, and further curve flattening/inversion. The long-end of the US Treasury curve meanwhile will likely remain much more anchored, taking its cue from Powell’s comments that the Fed will “restore price stability”, i.e. crush inflation, “even if it results in a sustained period of below trend growth.” The longer and harder the Fed pushes on the brake, the worse the economic slowdown. Hence, bonds in the ten-year plus maturity bucket can be a valuable hedge for investors.
We are revising our previous barbell strategy to one that emphasizes ten-year plus maturity bonds, with a preference for the longer (thirty-year) part of the curve. We would also implement a more neutral overall portfolio rates strategy.
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