Janus Henderson: Fed moves one step closer to rate hike

27 januari 2022

Jason England, Portfolio Manager at Janus Henderson Investors, believes that the U.S. Federal Reserve will continue down a data-driven, methodical path as it first initiates interest rate increases and then possibly utilizes its balance sheet to influence longer-dated interest rates.

In one of the more anticipated U.S. Federal Reserve meetings in recent memory and that did not feature an update to its Summary of Economic Projections, Chairman Jerome Powell offered few surprises.

In a unanimous decision, Fed officials left interest rates unchanged but did offer insight into its next steps as it guides monetary policy away from a regime of extraordinary accommodation.

Citing a level of inflation well above the Fed’s longer-term target of 2.0% and a historically tight labor market, Chairman Powell indicated that an initial rate hike would occur at its March meeting.

Yet, concerns about rising prices were not enough to cajole the Fed to pull forward the completion of its balance sheet tapering, preferring for it to continue on schedule into early March.

While many observers have been calling for an immediate 50 basis point (bps) hike, we don’t think that fits Chairman Powell’s modus operandi. In our view, he continues to act with deliberation, allowing the data to dictate future actions and communicating the Fed’s intentions well in advance of any policy changes.

A case in point were the guiding principles he discussed when approaching future policy. Of note was an emphasis that interest rates will continue to be the primary tool to adjust policy and that only secondarily would adjustments to its balance sheet be considered.

Deploying a blunt tool

Even with its historical bias toward dovishness, the Powell Fed has come to recognize that the time to raise interest rates is fast approaching. The fed funds target rate, however, is a notoriously blunt instrument that, when raised aggressively, can constrict economic growth and even lead to recession.

This is an outcome the Fed seeks to avoid given continued uncertainty about the future path of the U.S. economy. And by not committing to a specific number of hikes or changes to its balance sheet, the Fed is positioning itself to maintain a level of nimbleness to confront any unforeseen developments that could occur over the near- to mid-term horizon.

Our view is that they will lead with a single 25 bps in March, likely followed by two other 25 bps increases over the remainder of the year. Given the lag it takes for higher rates to flow through the economy, we would not be surprised if the Fed sticks to the quarterly meetings to observe the impact of its initial moves.

Still, with inflation having already stung the Fed once, we believe that should its call on moderating prices fail to materialize, rate hikes could potentially be on the table in any meeting this year.

A yield curve in motion

The expectation of higher policy rates has already exerted upward pressure on the front end of the Treasuries yield curve. We expect that to continue. The associated higher cost of capital would likely tamp down on future economic growth (and inflation) expectations, relieving some of the upward pressure recently felt on longer-dated Treasury yields. Accordingly, we can foresee a flattening of the yield curve as rate hikes commence.

While some flattening should be expected at this stage of the cycle, the Fed would not want the situation to get out of hand. Should stickier-than-expected inflation lead to the market’s estimate on 2022 rate hikes being more on target (they’ve recently risen from 4 to 4.5, while the Fed projects only 3), the yield curve could flatten too much and even invert.

That is considered an indicator of impending recession and the Fed would undoubtedly want to take steps to guide the market away from that conclusion. Another reason for the Fed to prefer a steeper yield curve is the presence of a term premium incentivizing the risk-taking that rewards capital for investing in the longer-duration investments that drive durable economic growth.

Past is prologue – again

More so than with shorter-dated maturities that tend to be tethered to policy rates, the market gets a vote on the level of longer-dated yields. Yet this time around, owing to the gargantuan size of its balance sheet, the Fed may have an additional tool in influencing these yields.

Should the curve come close to inverting, the Fed could adjust how it rolls off assets and even – should conditions merit – sell some securities.

We believe that even though the Fed downplayed the role of balance sheet reduction, conditions could unfold in a manner that would favor this scenario: a couple of rate hikes, a pause and if the curve flattens too much, the balance sheet could be deployed to put upward pressure on longer-dated bonds.

Should the Fed choose to take this course, we could envision the yield curve first flattening, then steepening later in the year.

This is largely theoretically as the Mr. Powell said precious little about the Feds plan to roll down its balance sheet. This, too, was likely by design. We believe the Fed is following last year’s taper playbook, when they first weren’t 'talking about talking about it', then 'talked about it' and ultimately came up with a framework they telegraphed to the market. Consequently, we believe the market will receive considerably more guidance on balance sheet reduction in coming meetings.

With inflation still present, and not just in the U.S. but globally, we believe that interest rate volatility will continue and that exposure to interest rate risk (duration), should be approached by investors with caution over the near term.