Should Investors Fear a Hawkish Tilt?
The market digested pronouncements from several central bank meetings last week. The Fed and the Bank of England delivered monetary policy decisions which were not that big a surprise for anyone on paper. Monetary policy rates and QE programmes remained unaltered, as expected, although the tone and rhetoric changed. On Wednesday, the Fed moved one step closer to tapering and even put quite a clear timeframe for it, while on Thursday, the Bank of England openly talked about rate hikes. Rates markets have reacted accordingly, with both Treasury and gilt yields selling off by circa 15 bps at the 10-year and the 30-year parts of the curves. There are several interesting observations worth highlighting.
Firstly, the Fed is starting to acknowledge that inflationary pressures will not be as short-lived as initially thought. As a result, they revised their own projections for Core PCE (Personal Consumption Expenditures) Inflation higher to 3.7% for 2021 and 2.3% for 2022. Interestingly, the latest Core PCE number was July's, and it came at 3.6%, the highest since the early 1990s. It's important to note that these Fed projections are Q4 over Q4 averages. In other words, they expect Core PCE to decline to a level that is still marginally above their target by Q4 next year, meaning the U.S. economy would spend several quarters with uncomfortably high inflation numbers. Therefore, there is a risk that consumers start to factor in higher future inflation, which could potentially affect wages. In turn, higher consumer expectations might mean that inflation takes longer to come down to target than expected—definitely one to watch.
Secondly, the Fed and the Bank of England have slightly different mandates. While the Fed can afford to focus more on labour markets than inflation, other central banks do not have that luxury. This distinction explains, in part, why the Bank of England explicitly recognised the possibility of a rate hike in relatively short order. This difference in reaction functions might not be a big deal most of the time. However, in unusual scenarios such as one characterised by solid growth, high inflation and slack in labour markets, those differences might impact market expectations for the timing of monetary policy moves. A compressed expected timescale for policy change affects the shorter end of yield curves. Accordingly, Gilt yields are higher than Treasury yields between 1-year and 3-year tenors, while this difference reverses for longer maturities.
Thirdly, both the Fed and the Bank of England adopted hawkish stances despite poorer near-term growth projections than expected a few months ago. The Delta variant and further supply chain issues have hurt growth in Q3. Both central banks acknowledged these challenges but decided to issue a more hawkish statement, evidence that, like us, they view this growth blip as temporary. Consequently, credit fundamentals should not be impacted and should remain very healthy.
Lastly, rates markets are vulnerable to a selloff. In the grand scheme of things, central banks retiring emergency monetary policy measures is not surprising given the economy is no longer in an emergency. What is more surprising is to see a 55 bps rally in 10-year Treasuries in the recovery phase of the economy, as we saw in Q2. Relatively compressed yields leave the Treasury curve a lot more susceptible to a selloff than if the 10Y UST was at 1.75%, especially in the face of potential monetary policy tightening.
In conclusion, the hawkish tilts by the Fed and the Bank of England, which come when growth is somewhat weaker and after a steep rally in rates, is negative for government bonds. But, at the same time, the implicit confidence in the medium-term economic recovery means the Fed and the Bank of England should not be too worried about credit fundamentals or the economy's ability to handle higher rates.
