Tighter Monetary Policy is Here
Strategy
While Covid remains the number one health threat and number one economic threat, the variants keep changing. We were negatively impacted by the Delta variant last quarter and now we have Omicron. While this variant is much more contagious, it seems to cause fewer serious symptoms. Some medical experts say this is how a pandemic ends; millions get infected by a much less serious variant, and we have herd immunity. The seasonal flu we have today is the result of the Spanish flu pandemic 100 years ago. Let’s hope the economy can remain open with this milder variant and not go back to remote learning and shutting down restaurants, gyms etc.
Looking at economic growth for 2022, it’s important to realize we are ending 2021 on a very strong note. GDP in the 4th quarter could be as high as 7.5%. The outlook for the 1st quarter of 2022 is also quite robust coming in at 4.0%. Businesses are still having a difficult time getting the necessary items they need to run their business. Restaurants can’t get Ketchup packets. Chicken breasts are in very short supply and very expensive. Auto manufacturers can’t get enough computer chips which has a very negative impact on GDP. In 2019, the U.S. had 17million in auto sales. That figure declined to 13 million in 2021, which is nearly a 25% drop. Finding workers is the other concern for business owners. There are 4 million fewer people working today than at the end of 2019. While that figure has been dropping steadily, it remains a very large number. The hospitality industry was hit the hardest. Some restaurants operate with limited hours, some hotels can only have certain floors available for guests, and lots at car dealers have a very reduced selection available. This provides many opportunities to spur growth as supply chain issues get resolved.
"The other major concern for economic growth is tighter monetary policy."
The other major concern for economic growth is tighter monetary policy. The market now expects three rate hikes this year. Pressure on interest rates seems to be almost a given, especially if inflation remains well above the Fed’s 2.0% target which is very possible as goods inflation has been joined by wage inflation. Wage inflation is not easy to bring down. Interest rates have risen sharply in early January as the 10- year T note yield went from 1.51% to 1.70%. The 3-year Treasury note was 0.40% in September and recently traded at 1.10%. While three rate hikes of 25 basis points each doesn’t seem like something to worry about, markets are not used to tighter monetary policy. Equities are very sensitive to rising interest rates and a correction in the stock market would likely lead to reduced consumer spending and ultimately lower economic growth (since 2/3rds of GDP is consumer spending)
We discussed CMOs last quarter and continue to find structures that look attractive. As a backdrop, the 3–4-year part of the yield curve has the best value on the short end. Generically, we can consider a Freddie Mac-backed sequential CMO. The base case average life is 3.5 years with a 9-year cash flow window. It is priced at 99.48 to yield 1.63% which is a yield spread of 52 basis points. The average life extends to 4.6 years at a slow prepayment speed. The investor receives 55% of their principal back within the first 3 years. If the Fed starts raising rates next year, this bond will provide excellent cash flow for reinvesting. Given the discount price, any increase in prepayment speeds results in a higher yield.
Our second example of a security area to research is an agency passthrough that has a 20-year maturity and a 2.0% coupon. Pools are priced close to $100.50, have a 5.8 year average life and yield 1.90%. The yield does not change much as the prepayment speeds vary since the purchase price is par. This type of pool will extend to a 7.2 year average life if rates increase 100 basis points. Looking at the cash flows, the investor gets 50% of principal back in 5.6 years. There is no credit risk as FNMA and Freddie Mac back these borrowers. This is a little longer option, but keep in mind the extension risk if rates due in fact increase.
"Investors in similar ABS securities will have all their principal returned by the middle of next year."
One asset class we have not mentioned recently is asset-backed securities or ABS. Let’s look at a subprime issue that is performing very well. Some existing issues have had excellent underlying collateral performance. Since issuance, the credit rating has improved to the “AA” rating category. A sample tranche has 28% credit support and using the current prepayment speed of 2.54, the yield is 1.18% to a 1.3-year average life. The yield spread is 48 basis points to like-term treasuries. This is a great place to “park” money in a rising interest rate environment. Investors in similar ABS securities will have all their principal returned by the middle of next year.
Our final example of an area of interest is a security we have used frequently over the years. It is a privately issued mortgage-backed security or what we call an RMBS (Residential Mortgage-Backed Security). Looking generically at a sample RMBS that was issued late in 2020 but the collateral used is 18 months old; it is priced at $102.5625 to yield 1.77% at 31 CPR with an average life of 2.30 years. The yield spread is a very generous 93 basis points to Treasuries. The bond has 27% credit support (originally 15%) and is AAA rated. At 20 CPR, the average life increases to 4.12 years and the yield is 2.30% (a yield spread of 108 basis points). The average loan-to-value ratio is 67%. The credit quality metrics are outstanding making this a very attractive addition to a portfolio.
Interest Rate Outlook - Inflation Takes Its Toll, “Transitory” is Retired, and Rates are Rising
The non-transitory nature of inflation was the backbone for many aspects of life in the 4th quarter. Politically, it was a significant contributor to the uncertain status of the Biden administration’s signature legislative program (the social infrastructure package). The possible addition of gas on the fire (that is the painful aspects of the current state of inflation) has moderate Democrats calling for a pause to additional fiscal stimulus. Given the divided nature of Congress, at a minimum, the size of the final package will need to be less than half of what was initially discussed (and it would be a third of what progressive Democrats wanted). Although negotiations between moderate democrats and the White House have stalled, there is a political need to deliver for constituents ahead of midterm elections, so we continue to expect something north of $1.5 Trillion will eventually pass.
The pain of inflation has hurt many people as wage growth has not outpaced the cost increases in some unavoidable areas, such as energy, food, and shelter. Many economists look at “core” inflation numbers, which strips out food and energy costs, due to their occasional volatility. The (not so) funny thing is that food, energy, and shelter costs absorb about half of the disposable income for many households (Source: USDA and Investopedia). According to the Atlanta Fed’s Wage Growth Tracker, as of November 2021, annual wage growth spiked to 4.3%. Although this sounds great, the annual rate of inflation in November, as measured by the consumer price index (CPI) increased a whopping 6.8%, so the average American lost purchasing power. Using the less volatile core CPI, the rate of inflation was 4.9% (Source: Bloomberg). Core inflation posted the largest jump in 30 years while the headline number (6.8%) exhibited the highest rate of growth since 1982! The net effect of all of this is that many people just earned a pay cut of 2.5% (on a real basis). It is no wonder why people are discussing the impacts of inflation and clearly the politicians and central bankers have taken note.
"Of note, the Federal Reserve expects unemployment to drop to 3.5% in 2022, below the long-term neutral rate of 4%."
At the Fed meeting in mid-December, they made a rapid policy shift, “the Powell Pivot,” to combat levels of inflation not seen in a generation. Even though the Fed expects inflation to naturally decelerate to 2.6% in 2022 and settle just over 2% in 2023, they retired the term “transitory” to describe inflation. Of note, the Federal Reserve expects unemployment to drop to 3.5% in 2022, below the long-term neutral rate of 4%. Just recently, the rate fell to 3.9%. Although allowing the employment market to “run hot” may push up wages for low and moderately skilled workers, and especially for the recently targeted minority groups by the central bank, it will very likely stoke the inflation fire. The CEO of Cargill recently said that although he hoped the recent 6.1% annual increase in food costs was transitory, he feels there will be continued food inflation pressures due to continued shortages in labor markets. Either people have to decide they need to go back to work, or wages have to rise such that they can be enticed back into the food processing plants and slaughterhouses. The Powell Pivot may go through a policy meatgrinder as a tight employment environment feeds into inflation and price pressures. As a reminder, the Fed’s dual mandate is full employment and price stability. Inflation in its various forms may continue to be the main discussion of the financial markets, politics, and at kitchen tables in 2022.
The Powell Pivot occurred in at least a couple of ways. First, the Fed announced that they were doubling the pace of the reduction in their program to purchase Treasury and mortgage-backed securities. Specifically, they are reducing the pace of purchases by $30 billion a month, so that the purchases will stop in March of 2022. Previously, the program was going to end mid-year. Second, the Fed telegraphed to the market, through the “Dot Plot” which depicts each FOMC member’s expectation for where they anticipate the Fed Funds Rate will be in each calendar year. Currently, the average of the “Dots” suggests that the short-term rate will be raised three times in 2022, to roughly 0.75%, followed by another two or three hikes in 2023 to a level that may exceed 1.50% in 2023. It isn’t until roughly 2024 that the Fed expects they will be approaching a neutral rate (where the Fed Funds Rate is in line with the rate of inflation). Perhaps a third way the pivot occurred was in the messaging following the Fed’s most recent meeting. They appeared to leave a window of opportunity to be more hawkish to fight inflation than what the market was expecting by announcing that they could hike before reaching full employment.
The Fed’s guidance offers a high degree of certainty that rates will rise. The Fed Funds Rate has anchored the short part of the yield curve near zero for nearly two years. A change in policy and increase in the Fed Funds Rate means short rates will rise. On the longer end of the yield curve, the largest balance sheet on planet Earth (the Fed) is stepping away from massive Treasury and agency-backed mortgage-backed security purchases, putting temporary upward pressure on yields. To elaborate, the Fed had been purchasing $120 Billion per month of US Treasury and mortgage-backed securities. The need for the purchases came during the liquidity freeze that occurred in the bond market in March of 2020 (the start of the pandemic). Liquidity has returned to the fixed-income markets and yield spreads have narrowed dramatically (spread is the incremental yield earned for holding bonds with some degree of credit risk as compared to similar-term US Treasuries). Broadly, the quantitative easing program has outlived its usefulness, but we remained concerned that volatility will return to the bond market as the largest buyer quickly leaves the market. That is certainly not to say that free markets shouldn’t operate without training wheels at some point, but investors who have benefited from well-behaved (managed) markets will need to gain comfort operating in a more volatile market. Volatility often offers opportunity.
"Between the Fed walking away from the bond market, technical influences, and behavioral flaws, we anticipate that there is tinder to drive yields higher in 2022."
As mentioned last quarter, convexity hedging may cause a feedback loop that following a spat of rising rates, may act to push yields even higher. It could very well send a false signal to bond market investors that the “smart money” expects growth rates to be elevated for the long term, justifying higher longer-term bond yields. In the past we have discussed the idea of regime switching models, the idea that people often think interest rates are either going up or we are going down (a switching of regimes). The extrapolation of data into an imagined trend is an example of a behavioral economic decision-making flaw that could further extend the false signal identified above. Between the Fed walking away from the bond market, technical influences, and behavioral flaws, we anticipate that there is tinder to drive yields higher in 2022.
Currently, many market experts think the Fed is behind the curve in their fight against painful degrees of inflation. We might offer that the Fed may find itself to be pinned by the curve, the yield curve. As they start to raise the Fed Funds Rate, conversations may turn from aggressive back-patting about how rates have risen, and we are on our way to 3% 10-year Treasury yields to cries that “the Fed is going to kill the recovery.” The adage, “don’t fight the Fed” often is good advice. The Fed raises rates to cool down the economy. They have many tools to accomplish their goal and the memory of a long period of disinflationary expectations is fresh in many people’s minds (and it is all that many people have ever known during their adult lives). ACG expects that when the concerns about Fed tightening are expressed, long yields will fall, and the Fed may find itself in the unenviable position of trying to rase rates against the headwinds of a flattening yield curve. The Fed will be loath to push short rates to the point where fixed-income investors start to worry about a yield curve inversion (where short-term rates are higher than longer-term yields). This challenge for the Fed is likely more of a 2023 issue than a 2022 concern and it is worth mentioning that asset sales by the Fed may be able to influence the longer end of the yield curve for a time.
Near term, base effects, and the removal of unprecedented levels of fiscal stimulus are the greatest threat to an orderly path to the Fed’s current expected policy path. Gas prices increased approximately 50% on a year over basis, which has been a particularly painful source of inflation for many people. It is not very reasonable to expect that gas prices can increase at a rate of 50% per annum for any meaningful period of time, because out of necessity, people would find transportation substitutes, consolidate trips or simply choose to be less mobile (the concept is demand destruction, when a good’s cost increases to the point people chose not to buy it). Trees don’t grow to the sky and commodity price increases are very likely dampened by their own gravitational force. With such outsized price increases as of late, subsequent periods are not expected to maintain the pace of increases, which on a comparative basis will look like a deceleration in inflation. The other near-term headwind is the removal of fiscal stimulus from many world economies. UBS estimates that that the removal of fiscal stimulus in 2022 will cause a drag of up to 2.5% from global GDP. That is five times greater than the austerity measures that followed the 2008 financial crisis. These influences may largely be what the Fed is banking on to glide inflation back to manageable and healthier levels.
"A more sustainable path is an educated workforce and encouraging industries that can use moderately skilled workers."
A wildcard that many people are talking about is the state of the employment environment. The good news for many U.S. workers is that compensation grew by the largest amount on record in the third quarter. The bad news, as we detailed earlier, is the increase didn’t keep pace with headline CPI. Data from the ADP Research Institute show that U.S. companies added the most jobs in seven months, this past December. On that basis it appears that Americans are returning to the workforce. While it is possible that the jump in wages has coaxed some people back to work, it may also simply be the case that more people decided that it was time to earn an income. According to the BLS, in November the number of jobs seeking people was over 10 million and the number of people looking for jobs (people who are unemployed) totaled just under 7 million. It suggests that wage inflation may have room to run for 2022. The degree to which this dynamic results in a wage inflation, and broader inflationary updraft, may be the source of risk that could cause the Fed to act in a way that surprises the markets. If the Fed has to slam on the brakes to moderate inflation, it may increase the risk of a recession. If labor force participation does not pick up, we may have another vexing issue (if people simply decide that they don’t want to work but they really want others to support them). Such a bifurcated employment market, those who work and those who are unwilling to work, could result in a head-spinning future with pockets of inflation and an economic drag on broader GDP at the same time. A more sustainable path is an educated workforce and encouraging industries that can use moderately skilled workers. Workers who experienced both the Great Recession and the pandemic during their formative and adult years understandably value a satisfying work/life balance, and employers who want to attract talent will have to address these needs to retain the best employees for the long run. A very real collaboration needs to occur between employers and employees about how to run a profitable and competitive corporation that is made up of satisfied and motivated people. Something must reverse the course of devalued human capital (from both the perspective of disaffected workers who don’t invest in their skill set and corporations who see their human resources as an unfortunate necessity).
Currently the growth of the labor force is roughly in line with the pace of new job openings. The continuation of this delicate dance may be crucial to the Fed being able to proceed with its orderly plan. Too many new jobs being created, relative to the number of people entering the workforce will likely result in inflation. A collapse in the number of new jobs relative to the number of job seekers risks a deflationary wage environment, which could precipitate a downward economic spiral, as people aggressively compete for jobs while experiencing the 2.5% “pay cut” that inflation has effectively handed them. If inflation is too many dollars chasing too few goods, the “job scarcity” environment scenario would be a version of too few dollars pursuing too many goods.
This is a difficult environment in which to make an interest rate forecast. Since we began writing this quarterly strategy, 10-year Treasury yields have risen from approximately 1.50% up to 1.75%. We expect the Fed’s tapering program will end in March and immediately they will posture themselves to raise the Fed Funds Rate at the May meeting, but the market is calling for a 90% chance of a hike in March. We would be onboard with that, but there is a bit of a challenge that the Fed may have created for themselves when they identified equitable wage growth as an expanded tangent to their “full employment” mandate. In the recent jobs report, black American unemployment ticked higher to above 7%, while white American unemployment declined further to roughly 3.2% (Source: CNBC). Given the broadened mandate and the political pressure to incorporate equity into the role of the central bank, it would seem like the bias for the Fed would be to let the employment environment run hotter than the market would prefer. We expect that all of this will result in a mid-year hike with rates broadly rising ahead of the hikes, and possibly into the first hike, with growing market concern that a program of several hikes will “kill the recovery.” In 2022 we could see 10-year Treasury yields exceed 2.0% that may be coupled with spread widening in corporate bonds, especially as the training wheels (Fed bond purchases) are removed from the market. Longer-term we expect that the U.S. will mimic aspects of Japan’s experience with debt, deficits, the need for cheap money being thrown at a population that may start saving more, and low yields for a long time.