The Fed takes a new hawkish turn
Brainard, who was nominated to become the Fed’s vice chairman, said the Fed would start shrinking its balance sheet “at a rapid pace” as early as the May meeting. She added that inflation was “subject to upside risks”.
Given its reputation for being keen to avoid too-rapid tightening, the comments were interpreted as a sign that the consensus among Fed officials is moving more in a hawkish direction. The market is now pricing in more than an 80% chance that the Fed will raise rates by 50 basis points at its May meeting, the first time it has risen by such magnitude since 2000. Overall, contracts futures point to 220 basis points. rate hikes this year on top of the 25 basis point increase from March. That would be the fastest rate of tightening since 1994.
The new hawkish tilt caused US Treasuries to sell off sharply, with the 10-year yield rising 15 basis points to 2.55%. On Wednesday, the yield rose further to 2.61%. The S&P 500 fell 1.3% on Tuesday, with cyclical sectors the most affected. Tech stocks, which tend to suffer disproportionately from rising yields, also fell. The tech-heavy Nasdaq closed down 2.3%.
Investors will now look to the release of the Fed’s March meeting minutes for further guidance on the pace of quantitative tightening and rate hikes.
Thus, the latest developments underscore our view that investors should consider strategies that work well in times of rising rates:
1. Opportunities remain in fixed income, despite still negative real yields on Treasuries across most of the curve. US senior loans offer some protection against rate increases due to their floating rate structure. The asset class also offers an attractive prospective estimated yield of 5.8%. For investors wishing to lock in their capital longer, the yield premium offered by direct lending can provide an additional cushion in this environment. We estimate that a typical yield for senior mid-market corporate loans is between 400 and 600 basis points above benchmark rates.
2. In equity markets, value sectors, such as energy and financials, tend to outperform when rates rise. We maintain a preference for US stocks, which are less impacted by rising yields and should benefit from relatively solid US economic growth. We also like Eurozone prime value, a style that combines both value and quality aspects, as a defensive option within equities. Financials also generally benefit from rising interest rates.
3. Investors may seek to profit from the divergent pace of central bank interest rate hikes and its impact on exchange rates. The DXY dollar index has climbed 3.6% year-to-date as the Fed is expected to tighten policy faster than the ECB and Bank of Japan. We also like the British pound and the Australian dollar, as their central banks are at the forefront of the tightening cycle. On Tuesday, the Reserve Bank of Australia dropped the word “patient” from its statement after April’s policy meeting, paving the way for a faster rise in interest rates. On the other hand, the Swiss franc and the euro are our least favorite currencies. We also expect the Chinese yuan to weaken moderately against the dollar amid divergent monetary policy dynamics between the US and China.
But while investors should brace for higher rates and risks to economic growth mount, our base case scenario remains that this will not tip the United States into recession. Household balance sheets are strong and we continue to see momentum since the end of COVID-19 restrictions. Therefore, we still believe that market volatility potentially offers better entry points for longer-term equity themes, such as 5G, robotics and smart mobility.
Main contributors – Mark Haefele, Christopher Swann, Daisy Tseng, Jon Gordon, Andrew Thompson
The content is a product of the Chief Investment Office (CIO).
Read the original report – The Fed takes a new hawkish turn, April 6, 2022.