Week ended April 8th 2022
HAWKISH FED DOMINATES SENTIMENT
“In their discussion, all participants agreed that elevated inflation and tight labour market conditions warranted commencement of balance sheet runoff at a coming meeting, with a faster pace of decline in securities holdings than over the 2017-2019 period.” – Minutes of the March 15-16 FOMC
Investors were mainly focused this past week on the degree, speed and severity of monetary policy tightening by the Federal Reserve. Federal Reserve Board member (and “vice-chair-in-wait”) Lael Brainard started things off on Tuesday morning reminding investors that rate hikes would come fast and furious, but she also threw in that the Fed could start shrinking its balance sheet as soon as May. The FOMC minutes from the March 15-16 meeting were released the following day (here), and confirmed Ms Brainard’s comments. I read through the minutes and included some interesting extracts and summary points that you can find at the bottom of this update (to go directly there, click here). To add fuel to the fire of the ever-more-hawkish Fed, ex-NY Fed Reserve president and Bloomberg Opinion contributor Bill Dudley then said in an interview on Bloomberg Surveillance that in order for the Fed to be effective in its quest to see off inflation, stock prices would need to decline (as a result of Fed tightening). You can watch Mr Dudley’s 5-minute interview on YouTube here, or read “If Stocks Don’t Fall, the Fed Needs to Force Them”. Needless to say, this confluence of news clobbered bonds and caused equities to sell off sharply on Tuesday and Wednesday as the reality of Fed tightening set in. Just when investors seemed to digest this news and markets stabilised on Thursday, sentiment turned sour again on Friday in the US equity market. The benchmark US index ended lower for the week, breaking a trend of three consecutive weeks of positive returns on the S&P 500 following a poor start to the year. Other measures of market risk, including a rally in select safe haven assets and higher equity market volatility as measured by the VIX, suggested that the road ahead might become rocky again.
Investors’ concerns generally continue to revolve around
inflation and the policies of central banks in the US, UK and Eurozone to bring this under control (note that March CPI for the US will be released Tuesday);
the ongoing Ukraine-Russia war; and
the COVID outbreak and shutdowns occurring in China, which could affect China’s growth this year (relevant as China is the world’s second largest economy).
It is also worth keeping an eye on the first round of Presidential elections in France, which are Sunday (March 10th), as President Macron faces off against several challengers, the most prominent of which is far-right candidate Marine Le Pen. Should no candidate win a majority on Sunday, the top two candidates will have a run-off second round election on April 24th.
THE MARKETS AND TABLES
Global equity indices were generally worse this past week, with the exception being the FTSE 100 and the STOXX 600 (Europe/UK index). Based on the last few years of under-performance, I would not have necessarily thought that the FTSE 100 would be outperforming other equity markets on a relative basis this year. The outperformance reflects the FTSE’s heavy composition of energy, commodity and exporting companies, and low concentration of technology companies. As energy and commodity prices have risen and Sterling has weakened, it has disproportionately helped many companies in the FTSE 100, explaining the index’s strong performance YtD. The STOXX 600 also managed to gain for the week. Based on data I could dig up for P/E ratios (TTM), both the FTSE 100 (15.1x) and the STOXX 600 (14.3x) remain substantially less expensive than the S&P 500 (22.7x).
In US equity markets, the Fed’s more hawkish rhetoric, covered in the introduction, caused equities to sell off broadly mid-week, before briefly stabilising on Thursday. However, tech shares took a beating on Friday, leading to a losing week in all of the US indices that I track. It is familiar theme when higher UST yields most adversely affect technology shares, and I doubt we have seen the end of this. The DJIA relatively speaking was the best performer on the week, reflecting its more defensive composition of large companies. Generally, it feels like we returned to a more defensive tilt in US equities as market risk ratcheted higher.
In US corporate news, the major focus was on
Elon Musk announced that he had accumulated a 9.2% stake in Twitter (TWTR, up 17.6% WoW), and then was asked to join the Board;
JetBlue’s (JBLU) unsolicited bid to buy Spirit Airlines (SAVE) for $3.6 bln. JBLU was down 19.6% WoW, whilst SAVE was up 19.2%;
Berkshire Hathaway’s (BRK-A, BRK-B) announcement that it had accumulated a 11.5% stake in HP (HPQ). BRK was flat WoW, and HPQ was up 8.5%.
The US Treasury market was again under intense pressure most of the week due to the ongoing hawkish rhetoric from the Fed and higher inflation expectations. Speaking of inflation, CPI for March will be released on Tuesday, and market consensus seems to be around 8.3%, which would be an increase from 7.9% in February. The yield on the 10y UST increased 33bps this week, to 2.72%, as investors ran for cover. The damage in the UST market was more severe for a change at the intermediate and long end of the curve, which probably makes sense since the 2-year UST has more severely borne the brunt of the Fed’s comments on tightening monetary policy until now. As a result of this price action, the yield curve – which had inverted on the first day of April – resumed its more normal upward slope, although the curve relatively speaking remains fairly flat.
As yields increase and the Fed embarks on its rate rises, mortgage rates are heading higher in the US, too. Benchmark 30-year Fannie Mae mortgage bond yields were 4.72% on April 7th according to FRED (see graph below), the highest level in a decade barring the 4Q2018 when markets were in disarray following a series of increases in the Federal Funds rate.
As mentioned in the opening section, gold and the US Dollar – safe haven assets – served up solid gains for the week as risk-on assets became less attractive. The Yen continued to buck the trend as the Bank of Japan monetary policy remains extremely accommodative, well out of synch with the Fed, the Bank of England and the ECB.
WTI crude oil seems to have found a range in the high $90-low $100/bbl area, at least for the time being. This is well off the highs of a month or so ago, but probably better reflects fair value. I would expect energy prices to remain under pressure as long as supply-constraints (including the sanctions on Russian oil and gas) remain as they are, and demand remains stable. Clearly, the combination of moderating economic growth, demand destruction from inflation and new supply will eventually cause oil prices to settle, although identifying an equilibrium price is a fool’s game. The US Congress got in the act last week through a House subcommittee grilling of major oil company executives, blaming them partially for profiting off of the sharp increase in gasoline prices. That sounds like a “blame game” to me, certainly partisan as well, since oil prices are very much a global phenomenon determined by supply and demand. Cryptocurrencies were under some pressure this past week as risk appetite fluctuated, with benchmark Bitcoin down 8.6% WoW.
I have read and listened to some discussions recently as to how corporate bonds have been fairly resilient in the face of sharp increases in underlying US Treasury yields. Spreads did stabilise a couple of weeks ago even as yields were pushing higher, but this past week – as risk seemed to come back into focus – high yield spreads widened even as investment grade (BBB) spreads remained stable, an indication of migration towards the safer end of credit.
Nonetheless, S&P Global Market Intelligence reported that corporate bankruptcies in the US were the lowest in 1Q2022 in at least 13 years, as you can see in the table below, meaning that credit fundamentals remain reasonably sound for the time being.
Yields were higher though in both the investment grade and high yield corporate bond indices, as you can see in the table below. Yields were more severely affected in the investment grade and higher tier end of the high yield market, where increases in underlying yields on US Treasuries generally have a more perverse effect on corporate bond yields.
EXTRACTS AND COMMENTS FROM THE FOMC MINUTES FROM THE MARCH 15-16 MEETING
“In their discussion, all participants agreed that elevated inflation and tight labour market conditions warranted commencement of balance sheet runoff at a coming meeting, with a faster pace of decline in securities holdings than over the 2017-2019 period.” The minutes suggested that the Fed will shrink its balance sheet (i.e. will begin quantitative tightening, or QT) by not reinvesting proceeds from maturing securities, although they also discussed a monthly cap ($60 bln USTs and $35 bln MBS), as well as a three-month phase-in once balance sheet runoff begins. The minutes later mentioned that QT this could begin as early as May, which means the Fed would decide at the FOMC meeting on May 3-4.
The Fed voted to increase the Fed Funds rate in March for the first since December 2015, but only by 25bps because of uncertainty surrounding Russia’s invasion of Ukraine. Otherwise, the minutes implied that there would have been a 50bps increase. Consistent with comments coming from Ms Brainard and other Fed members, the increment is likely to be 50bps per hike at upcoming FOMC meetings should inflation remain elevated. The one dissenting vote for only a 25bps hike at the March meeting not surprisingly came from James Bullard (wanted 50bps increase). The minutes suggested that the Fed had successfully conditioned investors in that expectations in the market towards an ever-more hawkish tilt were embedded. The Fed believes this is the case because of higher UST yields and wider credit spreads. They also noted that inflation is certainly not all demand driven. They discussed supply-chain bottlenecks for example.
The Fed's staff of economists reduced their growth projections for the US economy and raised their inflation projections. They expect US economic growth will gradually slow so as to be on pace to return to the economy’s long-term growth trend by 2024. They substantially raised their inflation projections – they expect PCE to be 4% this year, 2.3% in 2023 and 2.1% in 2024. They minutes note that the Fed believes that the risk to growth is skewed towards the downside, and the risk to inflation is skewed to the upside.