Fixed Income

Fed tapping the brakes might help maintain US cycle

While Donald Trump complains that the Fed isn’t helping his economy, careful tightening now, including some equity market bumps, may prevent more damage later.

12/11/2018

Stuart Dear

Stuart Dear

Deputy Head of Fixed Income

Last month we wrote: “On the one hand our expectations have been playing out nicely – strong US growth is forcing the Fed, worried that inflation is already at target and the economy is turbo-charged with tax cuts, to tighten by more than markets have expected. On the other, we also expected concerns around both higher rates/inflation and trade war escalation would unhinge risky US assets, which has not occurred, yet.”

Well, October certainly brought some weakness to risky US assets, triggered in part by the sharp rise in Treasury yields that occurred in the early days of the month. The yield move itself seemed largely driven by a notable increase in Fed hawkishness, which caught markets off guard given little new fundamental evidence. It’s unusual for a central bank to get more confident as it nears policy neutrality, at which point the case for further changes usually becomes less clear, however the Fed does appear more convicted now. As the equity selloff got underway attention seemed to focus on the apparent peaking of US growth (and profits) in mid-year — and even possible near-term weakness due to tariff-related supply chain disruption — contrasted against a Fed that seems determined to keep tightening on pre-determined path.

So what is the Fed up to? No good, according to Donald Trump! But Fed Chair Powell may be doing Trump a favour – by taking some of the wind out of the sails of US assets now, it may be helping prevent the build-up of excesses and therefore prolonging the US cycle. Similarly, with respect to inflation: despite no strong evidence that the modest firming in wages is broadening out to higher general inflation, the Fed seems intent to keep tapping the brakes now to prevent more damage later.

Despite the Fed’s apparent confidence, the tightrope gets trickier to navigate the higher it goes. Up through 3%, the Fed’s funds rate will start to get restrictive, and the trade-off between softening growth but still rising inflation becomes acute. We maintain both that US growth, despite decelerating, will stay firmly above trend, and that inflation risks remain to the upside – which will see the Fed at least stick to their plan, and thereby tighten by more than markets are expecting. Riskier assets may still do okay through this late stage until recession threat rises more materially, which is still about 18 months away on our modelling. However, with risk premia still low, and volatility likely to lift further with rates, we are cautious.  

At some point, looking for convergence of the strong US economy, and asset markets, with developed market peers will be a profitable exercise, though it’s probably still a little too early to position for this in size. Our view has been that other economies lift, though an absence of material inflation threat is likely to keep central banks relatively patient versus both the Fed, and previous tightening cycles. Australia is a case in point. The economy is doing well, as the fall in unemployment to a cycle-low 5% indicates, however the weakness in wages growth, and associated consumption, underlies a soft inflation pulse, affording the RBA time. Emerging markets do appear to be presenting more immediate opportunities, as they have been more beaten up by higher US rates and the strong USD.

We took advantage of the market gyrations of October to modestly reposition the portfolio – by buying about 0.25 years of US duration and lifting part of the US high yield hedge we have in place. These are useful tactical adjustments to positioning within a broader cautious theme – we still are running duration well below benchmark, hold exposure to inflation linked bonds, and limited credit risk.

Within rates, we’re short the US, Europe and Australia (vs benchmark) in equal amounts, and prefer to hold these shorts in policy-sensitive shorter tenors. Owning inflation-linked bonds in the US and Australia should help protect against inflation lifting by more than central banks can control through policy tightening. There will be a point at which it makes sense to hold significantly more duration – as the cycle ages further, policy risks shift and riskier assets look more vulnerable – however in our judgement we are not quite there yet.

In line with the above point, holding a modest amount of credit in the portfolio continues to make sense in order to seek a little carry and provide some diversification benefit. However, credit spreads in general remain priced for ongoing reasonable growth and low inflation, not central bank policy tightening and liquidity withdrawal. We therefore continue to avoid riskier US credit where valuations are most stretched, and prefer owning higher quality, shorter tenor Australian credit. In aggregate our absolute and relative-to-benchmark credit exposure is low.

Altogether our cautious positioning leaves the portfolio well placed to deal with a more challenging market environment ahead, and ultimately to respond to developing opportunities to position for more constructive future returns.

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