Markets Weekly podcast – 31 January 2022
As uncertainty over the future path of US rates continues to drive market volatility, Michel Vernier, our Head of Fixed Income Strategy, discusses what we can expect from the Federal Reserve, and what it all means for bond investors. Henk Potts, Market Strategist, also looks at the latest earnings results and what’s been driving strong US growth.
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Henk Potts (HP): Hello. It’s Monday, 31st January and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.
My name is Henk Potts, Market Strategist for Barclays Private Bank. Each week I’ll be joined by guests to discuss both risks and opportunities for investors.
Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then consider how fixed income investors should be positioned, as the Fed gets set to hike interest rates. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.
It was another rollercoaster week for global financial markets. Volatility surged, volumes jumped, and traders experienced wild swings. The dramatic movements were driven by the hawkish tone from the Federal Reserve, the US central bank.
Fears of an immediate full-scale conflict in Ukraine, and mixed earnings, as companies faced up to ongoing supply-chain disruption and inflationary pressures, although a strong fourth-quarter US GDP print and consensus beating in corporate earnings from the likes of Apple and LVMH, provided some upside support, although these weren’t enough to encourage the dip buyers to fully commit to taking advantage of the recent sell-off, which has wiped off more than $5 trillion from stock values since the start of the year.
In terms of market performance, the STOXX 600 in Europe was down 1.9% over the course of the week, recording its worst weekly decline in two months. The 4.6% decline that was seen in January, so far, is setting the index up for its worst monthly performance since October 2020.
Over on Wall Street, a strong close on Friday, driven by earnings, helped to erase weekly losses. A third of S&P 500 companies have now reported earnings, 78% have beaten analysts’ forecasts, according to FactSet data. The S&P 500 snapped a three-week losing streak, and was up eight-tenths of 1% over the course of the week, with energy and technology very much leading the way, while the Nasdaq was flat over the course of the week. Although we should recognise the S&P 500 is still down 7% in January.
Energy stocks have been boosted by crude prices, which traded near seven-year highs last week. Oil rose for a sixth consecutive week as heightened geopolitical risks surrounding Ukraine, and evidence of supply constraints on OPEC+ members, pushed Brent up to $91 a barrel.
Turning to Treasury yields, 2-year notes rose to 1.2% last week from around 0.7% at the start of the year, as the Federal Reserve took centre stage by setting out their path towards policy normalisation.
The statement was actually relatively clear. However, the guidance in the press conference provided much greater room for hawkish interpretation. As expected, the Fed signalled that the rate lift-off will occur in March. No surprise there, given the inflation mandate has been more than met. The Fed didn’t go as far as to say it had met the definition of maximum employment, but did describe the labour market condition as strong.
In terms of asset purchases, the Fed did not accelerate its pace of tapering, and signalled it would end purchases in early March. The Fed did update the balance sheet run-off principles and confirmed that balance sheet run-off will occur after the rate lift-off. The Fed Chair said further discussions would take place in the coming months, but the start of the balance sheet run-off could come earlier than previously forecast, and faster than in previous cycles. We now look perhaps for that announcement to come as early as the main meeting and start in June.
At the press conference, chair Jerome Powell refused to rule out a 50 basis point hike in March, or hikes at successive meetings throughout the course of this year, saying the Fed remains focused on the incoming data, which is likely to increase the importance of inflation prints and employment reports going into those meetings.
Jerome Powell stated the US economy and the labour market could cope with higher rates if warranted. US fourth-quarter GDP growth came in better than expected, 6.9%. The estimate was at 5.7%, compared to the 2.3% rise that we saw in the third quarter. The 5.7% growth registered in the full year of 2021 was the strongest since 1984.
Going back to the fourth quarter, growth was primarily driven by the rebuilding of inventories, which is expected to continue in coming quarters. Consumer spending, particularly on services, was positive. However, business investment remained weak on supply issues. Federal spending was also a drag in terms of growth.
So that was the global economy and financial markets over the course of the past week. In order to discuss the impact of tighter monetary policy, and what that means for bonds, I’m pleased to be joined by Michel Vernier. He’s Head of Fixed Income Strategy at Barclays Private Bank.
Michel, great to have you with us today. The Fed are now clearly indicating that first rate hike will be in March. If you look at the Fed’s dot plot, it says three increases during the course of this year. But as we know, the market has now started to price in as many as five hikes. What’s your view on the intensity of policy normalisation that we can expect in 2022?
Michel Vernier (MV): As you’ve commented already, the Fed could not have been much clearer with the rate hike in March. Powell said the Committee is of a mind to raise the Fed funds rate at the March meeting.
Now, the Fed has also made sure that everyone in the market appreciates that the Fed is very-much alerted and ready to fight inflation. Headline inflation remains, for the ninth month now, well above the 2% target. Secondly, the unemployment rate is at 3.9% and falling. The Fed now officially declared full employment in the US, so a hike in March is almost a done deal, as you say.
When it comes to the subsequent periods, the market, as you said, is pricing in five hikes for 2022 in aggregate. Inflation at 7%, wage growth at 4.5%, and with six million jobs added in 2021, no one can ignore that the market is very, very tight, as Powell himself described it, when he referred to the labour market.
But we mustn’t forget that some of the inflationary pressures are likely to ease. Supply-chain disruptions would get resolved the longer the economies are able to stay open, and the participation rate in the job market, which dropped as workers decided not to come back during the pandemic, is not to stay low forever.
So, we are talking about a now and a then when it comes to the economic situations or conditions in the US. And this is likely to reflect in the new Fed strategy, as Powell is ready to fight inflation with full force now, and put on brakes later, potentially.
I think trying to guess the number of hikes will be extremely difficult going forward. The Fed has officially scrapped the forward guidance, and will now act according to incoming data. For now, three hikes, as shown in the Fed’s dot plot, seem very plausible. But we equally see a good probability that the Fed, with its new voting members, will add another hike in its projections in the next meeting. Five hikes, as priced in by the market, seems a bit stretched for now in our view.
HP: We know that some commentators are suggesting the Fed could go further in March, and hike by 50 basis points, so what do you think the chances are of a half a point increase? If we did see that 50 basis points, what would that mean for yields?
MV: That’s a very good question. The rate future market is pricing in 30 basis points for March, which means it gives a small probability for a 50 basis points hike, instead of 25. A 50 basis points hike would, indeed, fit into the concept of front-loading as just explained.
For now, the Fed may believe that 25 step is sufficient to keep inflation expectations in check. However, should we see inflation prints remaining in the current elevated range in February and March, then the market may not be that confident any more that a 25 basis point step would be enough, and a 50 basis point step would be more likely. With such a step, the Fed would signal that it’s not only talking the talk.
Now, when it comes to yield curve pricing, yes, indeed, with a 50 basis points move the market would price in a more aggressive hiking cycle, and this would in turn mean even higher 2-year and 5-year yields. However, we believe that the Fed will also try to make clear that this may not necessarily lead to a more aggressive path, as it strongly believes that some of the inflationary forces will ease over time, and we would agree with that. This, in turn, may not result in a much steeper hiking path in the long term.
Finally, there’s also a good chance that with some lower CPI numbers in the second half of the year, the market must re-evaluate again. So even a 50 basis points hike now would not necessarily mean substantially higher yields in the long term.
Now, secondly, we need to look at the long-term neutral rate, the rate which the Fed is targeting. The dot plot suggests 2.5%, and despite inflationary pressures we can’t see this rate higher than that. The question here, now, is how many increases can the economy digest, and the Fed must weigh up between tighter financial conditions and fighting inflation, to a certain extent.
HP: Michel, let’s focus on the longer end of the curve. The Fed has announced its intention to reduce the balance sheet. Is this another reason for a rate sell-off?
MV: Yes, indeed. The Fed bond buying is about to end in March, and by mid of next year the Fed is expected to start to let Treasuries mature from the balance sheet.
Now, this could possibly mean a large shift in the supply/demand balance. We still lack some clarity at what speed the Fed will reduce the balance sheet, which is now at $8.9 trillion, compared to $4.5 trillion during the last peak. But we do know that we also have a substantial lower Treasury supply in 2022 compared to last year, so we would not expect that a reduction in the balance sheet would inevitably lead to a sell-off.
However, the pure uncertainty over the balance sheet normalisation will eventually lead to higher term premium. That’s the risk premium investors would demand for holding longer bonds, and this, in turn, could lead to somewhat higher long-end rates.
HP: So taking into account all your key forecasts that you’ve been discussing this morning, what’s the main message for bond investors today?
MV: So, even with the 2-year starting to price in multiple hikes, short-end yields are still low from an absolute measure and compared to inflation. Then we have higher uncertainty at the longer end, which is affected by the long-term inflation outlook and the supply/demand dynamics.
While we don’t see a trend change with 10-year rates rising well over 2.5%, there is a higher probability for higher volatility leading to yields over 2%, even if only temporarily.
And for that very reason, we like the 5-year point of the curve, as it’s not exposed to large price movements in the same way, and is yielding only 15 basis points less than the 10-year yields right now. So by diversifying into corporate bonds, investment grades, and high yields realising carry returns, investors are likely to achieve a real yield of around 0% within the bond part of the wider asset allocation.
By all means that’s not excessive returns but real protection with a relatively safer asset class, not more and not less.
HP: Well, thank you, Michel, for your insights today. We appreciate you keeping us updated on what is set to be an important few months for policymakers, and in turn, of course, markets.
Let’s move on to the week ahead. The central bank focus this week will shift across the Atlantic, from the Federal Reserve to the Bank of England. We expect the MPC to vote to hike rates by 25 basis points.
Back in November, the UK economy finally surpassed its pre-pandemic level, as output recovered more quickly than anticipated. The UK labour market is strong, remember, unemployment having fallen to 4.1%, job vacancies being at a record high of 1.25 million.
In addition, the service sector has been bouncing back. Consumers have been spending, and we’ve seen some strong prints coming through from the construction and manufacturing sector in terms of activity.
The concern, of course, for the central bank, as we see elsewhere, is the threat of inflation. Higher fuel and food prices, rising goods costs have all been driving up UK inflation. CPI hit 5.4% in December. Remember, that’s the highest in almost 30 years.
We forecast that CPI will peak at 6.6% in April, as Ofgem ups those price caps, before easing back in the second half of the year, although still see inflation printing at 3.6% in December.
The elevated levels of inflation, the labour market tightness, of course, encouraged the Bank of England to hike rates by 15 basis points in December. As we said, we expect the MPC to back that up with a 25 basis point increase this week, a further 25 basis points in May, putting the base rate at 0.75% by the time that we get through May.
In terms of data, this week the focus, of course, will be on the US nonfarm payrolls at the end of the week, Omicron, and weather disruptions expected to have held back employment growth during the course of January. Therefore, we look for nonfarm payrolls to rise just by 50,000, although we have to say consensus is significantly higher than that, currently running at 178,000, and we look for the unemployment rate in the United States to hold steady at 3.9%.
And with that, I’d like to thank you once again for joining us. We will, of course, be back next week with our latest instalment, but for now may I wish you every success in the trading week ahead.
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