Welcome to Thoughts on the Market. I am Vishy Tirupattur, Global Director of Fixed Income Research. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about fixed income markets amidst a time of extraordinary policy response. It's Thursday, April 8th, at 10:00 a.m. in New York.
A little more than a year ago, global equities bottomed as the pandemic wreaked havoc on the global economy, and caused jobless claims to spike to all time highs. It was also around this time that massive monetary and fiscal policy intervention began, matching the enormity of the pandemic. Today, hope is growing for light at the end of the tunnel, and we can finally see a path back towards normalcy.
On the policy front, the $1.9T American Rescue Plan has been more than double our base case expectations for 2021 fiscal stimulus, and another $2+ trillion of infrastructure package is in the works. The vaccine roll out in the US has gathered pace, and the timeline for vaccinations has been brought forward significantly. Clearly, the progress on the vaccination front has not been uniform globally, as parts of Europe and many emerging economies lag the US. But even so, growth is tracking the bull case narrative in our 2021 outlook.
However, in the last six to eight weeks, risk assets have seemed listless as interest rates have risen steadily. The benchmark 10-yr US Treasury yields have climbed about 60 basis points over the last two months. And that is where fiscal and monetary policy are meeting face to face - meaning it's time to think about monetary policy in relation to fiscal policy. So let's dig into the underlying tensions in this policy confluence.
The conventional response to stronger than expected growth, coupled with steep declines in headline unemployment, would have steered monetary policy towards tightening in anticipation of higher inflation. In fact, the bond market is pricing in a 25 basis point rate hike at the start of 2023, and two more hikes of that size by end of 2023. The thesis here is that trillions of dollars in stimulus, and an accelerating vaccination campaign, mean front-end rates cannot stay this low without inflation spiraling out of control.
However, the FOMC's 'dot plot', Chair Powell's comments during the last post-FOMC meeting press conference, and subsequent pronouncements by Fed officials have been stridently dovish, and notably at odds with the bond market. My colleagues, Ellen Zentner and Matthew Hornbach, note that, "Policymakers did not just 'double down' on dovish guidance, they 'tripled down'."
Even though the median FOMC participant now believes core inflation will remain at or about 2% through 2023, that alone is not grounds for thinking about rate hikes, because strong labor market conditions consistent with maximum employment take primacy in the Fed's reaction function. The Fed has not just raised the bar on the timing of future rate hikes. In fact, the chair sounded equally dovish on tapering asset purchases when he said, "We have said that we would continue asset purchases at this pace until we see substantial further progress, and that's actual progress, and not forecast progress. That's a difference from our past approach."
The conventional policy response reflected in the bond market stands in stark contrast to the Fed's clear message. Will the market move towards the Fed, or will the Fed shift its reaction function towards the market’s conventional thinking? Our global macro strategists believe in the former, suggesting investors treat the recent technically driven price action as noise, and focus on the signal from the Fed.
Our economists continue to expect that conditions would be in place for the Fed to raise rates in third quarter of 2023, with balance sheet tapering starting in January of 2022. Clearly, we are in uncharted waters in terms of policy. As my colleagues in US equity strategy caution, this policy response may mean that the current economic cycle could run hotter, but shorter, than the prior three cycles. They posit that the risk asset leadership is already shifting from early cycle to mid cycle, and that investors may want to position accordingly.
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