These forecasts compare with 0.875%, 1.625% and 2.125% indicated in the December meeting of last year. Current projections imply that the US central bank would raise its policy rate at each of the remaining six meetings in 2022. In fact, before the Fed meeting, the US yield curve had incorporated seven hikes (of 25bps) in the monetary policy rate this year and a little more than two in 2023.
The Federal Reserve raised its inflation projections for the next three years and lowered its growth projection for 2022. The monetary policy committee expects inflation of 4.3% in 2022, 2.7% in 2023 and 2.3% in 2024, figures that compare with 2.6%, 2.3% and 2.1% in the December projections.
In terms of economic growth, the 2022 projection was revised to the down to 2.8% from 4%, while in 2023 and 2024 a GDP expansion of 2% is expected, similar to what was projected in December.
Thus, the Federal Reserve adjusted its projections in a similar way as the European Central Bank did on March 10, raising its inflation estimates and lowering its growth estimates.
It should be noted that both central banks they expect a limited impact on economic activity derived from the war in Ukraine (The European Central Bank expects an economy growth of 3.7% in 2022 and 2.8% in 2023). In fact, regarding this last point, the Fed’s statement on Wednesday highlighted that the events in Ukraine increase uncertainty, but in the short term they generate inflationary pressures and weigh on economic growth.
Not much room for maneuver
The Federal Reserve faces the worst initial conditions (in terms of inflation, activity and unemployment) since at least 1988. Inspecting some basic elements for conducting monetary policy, such as inflation expectations, the unemployment rate, the output gap, among others, all point to the The Fed faces the most challenging outlook – in terms of initial conditions – in years.
While inflation stands at 7.9% y/y, the highest since January 1982, 12-month inflation expectations are at 2.77%, the highest level since records began (January 1998). .
Something similar occurs with implicit inflation in financial assets, better known as break-even inflation, which is measured through the differential between nominal and real interest rates for US treasury bonds.
The unemployment rate at 3.8% is not only at pre-pandemic levels, but also at the lowest at the start of any of the last monetary tightening cycles since 1988. The gap between gross product and potential shows that the economy of The US is growing above its potential at 1.4%.
Thus, one could continue listing elements that show that the initial conditions in terms of the key variables for conducting monetary policy are found in the tightest levels in several decades. This leads one to think that the Federal Reserve does not have much room other than to conduct a rapid adjustment in the monetary policy rate to avoid an unanchoring of inflation expectations and second-round effects on prices.
The cycles of adjustments in the monetary policy rate of the Federal Reserve bring about two events in the yield curve: (1) rise in the level of rates and (2) flattening of the same. Since the monetary policy rate acts as a floor for interest rates along the US Treasury yield curve, a rise in it generates an upward movement in the rest of the rates.
Because the yield curve moves ahead of Fed decisions, the rate level, estimated empirically as an average of 3-month, 2-year, and 10-year rates, tends to rise in anticipation of monetary policy decisions. and even once the adjustments elapse.
The other effect seen during Fed tightening cycles is that, Although all rates generally rise, short-term rates do so to a greater extent than long-term rates.so that the slope of the curve tends to flatten during monetary tightening cycles.
Heading into the next recession or emulating Alan Greenspan in 1994?
With the exception of the last one, product of Covid-19, recessions in the US since at least 1980 were preceded by the rise in the monetary policy rate. The question for the current cycle is whether the chairman of the Federal Reserve, Jerome Powell, and the rest of the members of the monetary policy committee will be able to emulate what he did Alan Greenspan in 1994 by adjusting the monetary policy rate in 300 basis points without taking the American economy into a recession.
Although with Russia’s invasion of Ukraine, the risks of a global recession increase due to the shock generated to commodity prices and the increase in uncertainty, the market began to incorporate as of this year that the Fed will probably have to unwind the tightening cycle of monetary policy by 2024.
This could be reflecting the concern that the Fed will have to make a frontal and abrupt monetary adjustment, which ends up triggering a potential recession towards the end of 2023-early 2024. According to a recent article by former US Treasury Secretary Lawrence Summers, the probability of a recession in the US within one or two years is “extraordinarily high”.
With a monetary adjustment cycle that is estimated, for now, at 250-275 bps and in a period that could last only 12 months, similar to the three Fed adjustment cycles between 1988 and 2000, it will be convenient to monitor the slope of the yield curve in the US. This is usually a very reliable indicator (precedent) of US recessions, particularly when reversed.
Although a recession is not to be expected this year, towards the end of 2022 and the beginning of 2023 it will be necessary to keep in mind what the differential in US Treasury rates shows for 3-month and 10-year bonds and the same measure for 2 and 10 year bonds. For now, it is convenient to position ourselves before the monetary tightening cycle.
How to position yourself against the monetary adjustment cycle: a look from the American treasury bonds
The tightening cycle that the Federal Reserve initiated will more closely resemble the tightening cycles between the years 1988-2000 than those that occurred between the years 2004-2018. This entails highly relevant implications for the positioning of fixed income, particularly in the US.
As indicated above, the monetary policy rate adjustment cycles generate two impacts on the yield curve, a higher level of rates and a flattening of the curve. Given that interest rates of shorter duration (in the short part of the yield curve) provide greater protection and less volatility against the rise in the monetary policy rate, even so, they do not prevent potential losses, at least at this stage. of the cycle.
This is due to the fact that interest rates continue to adjust upwards throughout the monetary tightening cycle, despite the fact that the increases are already incorporated in the yield curve.
In this environment, overweighting strategies with variable rate bonds over fixed rate ones in fixed income allocations within portfolios should generate a higher level of protection before the cycle of raising the monetary policy rate that we will be going through in the coming months.
Wealth Management Research – Balanz Capital
Source: Ambito
