BlueBay AM: If the Fed is a follower...

BlueBay AM: If the Fed is a follower...

Vooruitzichten Fed
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Mark Dowding, CIO at BlueBay Asset Management, has issued his latest market commentary. This week, he focusses on the Federal Reserve, US growth and inflation expectations and differing economic trajectories between Europe and the US.

This week’s Federal Reserve (Fed) meeting saw Jerome Powell deliver a dovish message, with FOMC projections seeing rates held unchanged at levels close to 0% until the end of 2023, notwithstanding material upgrades to both growth and inflation forecasts.

In many respects, we would observe that the key message from the Fed is that it will plan to react to data and will only move policy after the data shows the economy back at full employment and inflation at, and moving above, target.

In this context, it is not clear that there is very much information content in future Fed expectations when it is in ‘wait and see’ mode. It is telling the markets that it will be economic data that counts, and so this should really be the area where market attention is directed.

Robust US growth

We expect incoming information to point to robust US growth over the coming months. Our projection for 7%+ GDP growth in the US this year is above Fed projections. Similarly, we expect further gains to be made on employment, beyond forecasts coming from the broader market consensus.

We also believe that risks are tilted towards a higher inflation outcome than many others are discounting. After moving towards 2.5% in the spring, we doubt that inflation will drop below 2% during the summer and that it will be on a rising trajectory once more by the end of the year, as pent-up demand from a booming consumer meets supply and capacity constraints, thus allowing firms to exert more pricing power than they have had for a number of years.

Based on our own understanding of the US economy, we consequently believe that the Fed may still find itself in a position to be hiking rates at the end of 2022, after commencing tapering at the end of this year. Therefore, we see scope for yields to continue to move higher.

Indeed, it has been interesting that the initial moves in the wake of a dovish Fed have been for yields to go up rather than down – albeit with the curve moving steeper, as investors price increased medium-term inflationary risk to an overly dovish Fed.

Nevertheless, in addition to a rise in inflation break-evens, real yields have also moved higher in the latest move. From this viewpoint, it would appear that we remain in a bear market for yields, broadly speaking.

It could be extrapolated that investors are concerned that they are over-exposed to duration risk at a time when economic strength suggests that risks to yields are skewed much more to the upside than the downside in the months to come.

Immediate outlook

Notwithstanding a medium-term bias to higher rates, it is worth reassessing the shorter-term outlook following a material move in yields in the past few months.

Looking at valuations in the Treasury market, the 10-year yield stands at 2.0% on a one-year forward basis. Meanwhile, the five-year, five-year forward has moved above 2.6%. These forward indicators suggest that value is emerging in the eyes of some investors and from that standpoint, further information may be needed to sustain and maintain higher yields.

Since the start of 2021, 10-year yields have risen by 80bps in pretty much a straight line. So, in the short term, there may be logic in locking in some profits on short positions, while using any rallies in yields as an opportunity to add risk on short rate bets.

Europe

European markets continue to track developments across the Atlantic, yet the economic trajectory remains on a very different path compared to the US. A building third Covid wave is seeing a number of EU countries add to restrictions on economic activity and the slow pace of vaccination is also starting to put the summer of 2021 in some doubt.

The economies of southern Europe depend heavily on tourism receipts. In the weeks ahead, there may be growing concerns with respect to another ‘lost summer’ if progress in containing the virus and vaccine deployment cannot be accelerated.

Eurozone growth figures for 2021 may only be half of the US level and although the EU may catch up later in the year, in the course of the next several months we expect the gap in relative economic performance versus the US to widen. This also appears likely to be the case in the UK.

To-date, the UK has been lauded for its vaccination success. However, news on supply issues that mean jabs to anyone under the age of 50 are now on hold (with second jabs to the over 50s being the priority in the next 2-3 months), means that the exit from lockdown could be put at risk.

Risk assets

Away from rates markets, risk assets were initially cheered by the dovish message coming from the Fed. However, renewed pressure on government yields remains a source of concern and continues to temper risk appetite. US equities remain close to record highs and financial conditions are accommodative.

Corporate credit spreads remain relatively stable, but there is a sense that the rally in credit has lost momentum and we are seeing spreads trade in more of a range. It is also notable that we are approaching quarter-end over the next few days, with this also marking the end of the Japanese fiscal year.

Over the past several years, there has been a loss of liquidity and a bias to risk-off sentiment around the March quarter-end, so it is possible that a more positive tone re-emerges as we move into April. However, it seems that this may be contingent on moving into a period in which there is more stability in underlying Treasury yields.

This narrative can also be applied to emerging markets (EM). Credit spreads in EM have tended to be more volatile than in developed markets over recent weeks. Subsequent to this, EM spreads have rallied in the wake of the Fed, having been soft in the run-up to the meeting.

FX

Meanwhile, the dollar was slightly softer following the FOMC, though price action thereafter suggests that FX direction remains closely tied to the trajectory of yields. As we assess the relative trajectory in economic performance, we are inclined to look for a stronger dollar over the course of the next several months.

Although a booming consumer may mean that there is a widening of the US current account deficit, we believe that US growth exceptionalism will be consistent with a firmer greenback, with a strong dollar supported by the US administration, as a factor than can help ensure that transitory inflationary impulses are tempered.

However, unlike the pattern of recent months, which have seen the bulk of dollar strength against EM currencies, we would now see this mostly relative to other developed market currencies. As a result of this, we have moved to a long dollar stance versus both the euro and the pound during the past week. In EM, our currency views are more relative value in nature, with longs in Mexico and Colombia versus shorts in South Africa and India.

Looking ahead

The next significant data release will be the March US labour market report in two weeks’ time. As such, there may not be much news to drive prices over the coming few days with no planned fiscal or monetary policy announcements scheduled.

This could mean that price action is relatively technical in nature and this leads us to be a little cautious as we approach quarter-end – even if we think that we could see some consolidation in Treasury yields following the latest move higher.his weekend marking the 12-month anniversary of lockdown in the UK.

As we look forward to economic activity normalising, we are struck that the landscape looks set to expose some clear success stories as well as casualties of the crisis. This should be true on a corporate and sectoral basis, and also seems likely on a country basis too.

A dovish Fed may sound like a panacea for the strugglers and the stragglers. However, if we are right on the underlying trajectory of the data, it strikes us that Powell (or his successor) may be speaking very differently in 12-months from now. In the past, the market mantra was ‘don’t fight the Fed’. Maybe looking forward, the revised mantra should read ‘don’t fight the data’.