The Federal Reserve (Fed) taper is all but imminent this afternoon. Everyone knows it, which is why it shouldn’t produce a big market reaction. Instead, the markets’ attention is likely to turn immediately to what’s next.
Assuming the Fed winds down its asset purchases in mid-2022, when is the rate hike coming? In this week’s commentary, we discuss why the Fed might take a more dovish stance in 2022 than what the markets are currently pricing in and how investors should consider positioning portfolios today and longer term.
Markets are looking for a rate hike almost six months sooner than the Fed
The Fed fund futures markets are currently pricing in the first rate hike to occur by June of 2022 – right around the same time the Fed is expected to finish its bond purchases. This is much sooner than what we experienced during the last tightening cycle. October 2014 marked the last time the Fed stopped quantitative easing purchases, but back then, the Federal Open Market Committee waited over a year – until December 2015 – to hike rates. 1
Also, the futures markets’ pricing is more aggressive than what we saw in early September when the first rate hike was priced in for the fall of 2022. This is in contrast to the Fed’s own dot plot, which pencils in the first hike for 2023.2 So what’s caused this repricing since September and divergence from the Fed’s own expectations?
Inflation expectations are high but recently pulled back
The biggest driver of aggressive Fed fund futures market pricing has been the evolving market perception that inflation is anything but transitory. Indeed, forward inflation expectations rose sharply between September and late October, increasing from 2.14% to 2.4%.3 The markets assumed – and some Fed officials have intimated – that this higher inflation expectation could trigger the Fed to initiate rate hikes soon after tapering begins. This is especially the case since the rolling three-year average inflation should reach 2.4% by June 2022.4 Is this enough to constitute inflation that is “on track to moderately exceed two percent for some time” and would therefore trigger rate hikes? Perhaps, but a lot could happen between now and June.
While inflation expectations are elevated, they have declined meaningfully recently, easing pressure on the Fed.5 There are a few reasons for this. First, we expect supply chain bottleneck to begin to abate, and already, container shipping rates are falling.6 Additionally, while oil is surging for now, it could come off its highs in the spring of 2022, when the balance is forecast to flip from a deficit to a surplus as production recovers. Targeted lockdowns in China driven by a fresh round of COVID outbreaks may also dent China’s oil demand once again.
Labor force participation is at its lowest point in 45 years
Aside from inflation, the deciding factor in the Fed’s decision to hike rates will be achieving maximum employment, and that could take longer than the headline unemployment rate might suggest. This further supports the case for the Fed to be more dovish on rate hikes.
The Fed expects the unemployment rate (currently at 4.8%) to drop to 3.8% by the end of 2022, just a touch above the 3.5% low that we hit pre-pandemic.7 While this might sound good on the surface, two other measures will be equally important to get a true gauge of our distance from maximum employment. The first is U-6 unemployment, which counts those who are employed part-time but wish they were full-time and those who are marginally attached to the labor force. The U-6 rate today is 8.5% versus the pre-pandemic low of 6.8%.8
Second, the labor participation rate, a ratio of the employed to those in the labor force seeking employment, will also be heavily scrutinized. At 61.6% today, this ratio is at its lowest point in 45 years! Demographic trends and early retirements are partly to blame for this number, but the participation rate for workers aged 24 to 54 years is also 1.3% below pre-pandemic levels (81.6% versus 82.9% in December 2019).9 The Fed may want to see this ratio tick higher to ensure that we are as close to maximum employment as possible before it begins rate hikes.
Additionally, the Biden Administration’s Build Back Better plan aims to bring one million parents back into the labor force through expanded access to childcare options.10 If the bill passes, however, it might take some time for this cohort to find jobs.
The Fed meeting today (and especially the one scheduled for December) should shed some light on their likely reaction to higher-than-expected inflation and progress on unemployment. Our current view is that the Fed may want to put some distance between the end of tapering and the beginning of rate liftoff. If they do, this should prompt a lower two-year yield, higher 10-year yields, a steeper yield curve and, likely, outperformance from cyclical assets. The market overall should react positively to the fact the tightening cycle is not imminent. Still, faster or slower, rate-hiking cycles in the past caused rate-sensitive short-term fixed income to underperform, while equities fared well, including growth equities.11 This is why “the tale of two cities” performance of 2021 that saw equities hit record highs while fixed income languished (as seen in the chart below) could be repeated in 2022, except with more muted stock market performance likely.
The bottom line for investors: Don’t fear the taper, but if a more dovish Fed causes a rally in short-term fixed income, consider using that rally to prepare your fixed income portfolio for the upcoming rate-hiking cycle. We think private credit is one of the better places to be in a solid-growth and rising-rate environment.
(1) Source: Federal Reserve Bank of New York, Markets & Policy Implementation.
(2) Source: Bloomberg, as of November 2, 2021.
(3) Source: Bloomberg, as of November 2, 2021.
(4) Source: Federal Reserve, Summary of Economic Projections, September 2021.
(5) Source: Bloomberg, as of November 2, 2021.
(6) Source: Bloomberg, Drewry WCI Composite Container Freight Benchmark Rate, as of October 28, 2021.
(7) Source: Federal Reserve, Summary of Economic Projections, September 2021.
(8) Source: U.S. Bureau of Labor Statistics, Current Employment Statistics, September 2021.
(9) Source: Bloomberg, as of October 2021.
(10) Source: The White House, FACT SHEET: The American Families Plan, April 28, 2021.
(11) Source: Bloomberg, as of October 2021.
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