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FIXED INCOME
ON MY MIND: A DIFFERENT KIND OF PIVOT
November 2, 2022
Markets hoped for a dovish Federal Reserve “pivot,” but got a hawkish surprise
instead. Brace for more volatility as the yield curve adjusts, warns Franklin
Templeton Fixed Income CIO Sonal Desai. She sees the fixed income outlook as
more constructive moving further forward in 2023.
After the November 1-2 Federal Open Market Committee meeting, markets must have
wondered if Federal Reserve (Fed) Chair Jerome Powell dressed as the Grinch this
Halloween.
Financial markets went into this November Fed meeting hoping for a “pivot,” a
signal that after today’s expected 75 basis point (bps) hike the Fed would
switch to a few smaller rate moves, then pause, and sometime next year start
cutting rates again. Markets were convinced this would validate the drop in bond
yields that took place last week, and turn it into the beginning of a steady
decline. A fairly rosy and constructive scenario.
Powell snatched it away.
Asked about the December meeting, he left a glimmer of hope, saying we could see
another 75 bps move or a smaller one, depending on the data. At this point of
the press conference, market moves made it clear investors thought he was
opening the door to a smaller hike.
Then came the cold shower—more like an ice-cold waterfall. Don’t think about the
pace of hikes, said Powell—what matters now is how high rates go. They will go
higher than the Fed previously thought, he said, and they will stay higher for
longer—it’s very premature to even think about a pause. The Fed has not done
nearly enough yet, he added. Inflation is still way too high and core inflation
shows no sign of coming down. And the Fed is not worried about
overtightening—policymakers know how to correct that if it happens. He said the
Fed worries—a lot—about not tightening enough (or cutting too soon) because then
inflation will become really entrenched.
All this confirms my long-standing view that the policy rate will go higher than
markets think, it will stay higher for longer, and investors should not expect
rate cuts in 2023. I got the distinct impression that Powell does not want to
pause until he’s comfortable that the policy rate is high enough—he does not
want to pause and then have to resume hiking because inflation still does not
come down. He wants to err on the high side.
I think the fed funds rate will likely peak around 5.25%-5.50%.
Powell conceded that the policy rate needs to rise above the core inflation
rate, because if the real policy rate is negative, clearly policy is not tight
enough (as we argued very early on, when the Fed’s own forecast assumed that
inflation would come down even with negative policy rates).
The Franklin Templeton Fixed Income team projects the core Consumer Price Index
(CPI) to remain at 6.5% through the end of this year, and to still be above 6%
in the first quarter 2023 and little below 6% in the second quarter. Core
Personal Consumption Expenditures (PCE)—the Fed’s official target—will be
somewhat lower, so that will allow the Fed some leeway, but Powell has
previously acknowledged that the Fed does also look at CPI, because that is what
matters to people. So, I think the fed funds rate is headed toward 5.5%, and
markets still need to absorb this across the yield curve. To be clear, looking
further forward into 2023, my outlook for fixed income is also quite
constructive; however, we will first continue to face bouts of volatility like
we have seen in the past few months on the back of each new datapoint as the
yield curve adjusts to this scenario of a more hawkish Fed.
I also feel confident that we are unlikely to see rate cuts next year—very much
against what markets keep expecting. If our forecasts are correct, and core
inflation remains stubbornly high into 2023, the energy-driven decline in
headline inflation will not give the Fed much comfort. The Fed will want to feel
confident that core inflation is coming down toward its 2% target in a sustained
way. And if we are right in projecting that core CPI will still be uncomfortably
elevated as we approach the end of next year, a fed funds rate of 5.5% would not
seem excessively high. Remember, Powell said the Fed doesn’t want to risk
cutting too soon.
What about the impact on the economy? Powell admitted that a recession is more
likely than not, but indicated it should be a mild one. I agree, for the same
reasons Powell mentioned: the labor market is still extraordinarily tight, and
consumer spending is well supported by high saving. A mild recession, if still
accompanied by high inflation, is unlikely to move the Fed off its stated path.
And the impact on markets? The press conference provided a revealing experiment.
Toward the end, Powell was asked how he felt about the fact that markets had
rallied in response to the press conference. At that point, this was old news:
markets had initially rallied, then sold off—but Powell would not have known it.
In response, Powell just reiterated his message: rates will go higher than
previously envisaged and stay higher for longer; the Fed is not afraid of
tightening too much, it’s afraid of tightening too little or loosening again too
soon; and no-one should doubt the Fed’s determination to bring inflation down.
We said this would happen, because high inflation would give no other choice.
The Fed that used to prioritize asset prices now will lean against markets to
bring inflation under control.
That’s indeed a pivot. Just a different kind of pivot than markets expected.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. The value
of investments can go down as well as up, and investors may not get back the
full amount invested. Bond prices generally move in the opposite direction of
interest rates. Thus, as prices of bonds in an investment portfolio adjust to a
rise in interest rates, the value of the portfolio may decline.
IMPORTANT LEGAL INFORMATION
This material is intended to be of general interest only and should not be
construed as individual investment advice or a recommendation or solicitation to
buy, sell or hold any security or to adopt any investment strategy. It does not
constitute legal or tax advice.
The views expressed are those of the investment manager and the comments,
opinions and analyses are rendered as at September 30, 2022, and may change
without notice. The information provided in this material is not intended as a
complete analysis of every material fact regarding any country, region or
market.
All investments involve risks, including possible loss of principal.
Data from third party sources may have been used in the preparation of this
material and Franklin Templeton (“FT”) has not independently verified, validated
or audited such data. FT accepts no liability whatsoever for any loss arising
from use of this information and reliance upon the comments, opinions and
analyses in the material is at the sole discretion of the user.
Products, services and information may not be available in all jurisdictions and
are offered outside the U.S. by other FT affiliates and/or their distributors as
local laws and regulation permits. Please consult your own financial
professional or Franklin Templeton institutional contact for further information
on availability of products and services in your jurisdiction.
The information in this document is provided by K2 Advisors. K2 Advisors is a
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Posted in Fixed Income, PerspectivesTagged Fed pivot, Franklin Templeton fixed
income, Monetary policy, Sonal Desai, US Federal Reserve
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