How Costly Is Reducing Inflation?
The Fed’s recent hawkish attitude implies that there is still a trend of continued interest rate cuts in the future. This article will analyze and forecast the changes in the US bond market based on the recent trend of corporate bonds and mortgage-backed bonds, as well as the latest attitude of the Federal Reserve.
Graph From: https://www.haver.com/
At the Jackson Hole symposium on Aug. 26, 2022, Jerome Powell stated that the Fed’s “overarching focus right now is to bring inflation back down to our 2% goal.” and “The historical record cautions strongly against prematurely loosening policy.” In addition, based on the CPI report on Sep.13: August CPI rose +0.1% m/m and +8.3% y/y, stronger than expectations of -0.1% m/m and +8.1% y/y, which is a disappointing signal to the market.
This is highly likely to suggest that the Fed will raise rates by 75 basis points (or Even more) at next week’s Federal Open Market Committee meeting. President of the Federal Reserve Bank of San Francisco Mary C. Daly also supported a 50 or 75 bp rate hike in September, saying the Fed will not stop the pace of rate hikes soon and that tightening will continue until at least 2023. While the labor market is especially strong, the demand for workers substantially exceeding the supply of available workers. Therefore, the possible recession will be characterized by sustained high inflation and enterprise deleveraging.
“Tolerance” of Inflation:
Since if the Federal Reserve raises interest rates too aggressively, it may significantly increase the pressure on the US government to repay its debts. And to avoid the economy falling into a deep recession, the Fed may choose to tolerate a certain amount of inflation, that is, not seeking to press inflation back to 2% in the shortest possible time. So, it is likely to engage in sustained tightening without resorting to an aggressive rate hike margin. This suggests that after the federal funds rate reaches about 4.5%, the Fed may not raise rates significantly. Therefore, based on the analysis, we thought the possible recession will last for a longer time, and it is difficult for US bond yield to peak in a short time. The stock market and bond market remain sluggish.
Corporate bonds and mortgage-backed bonds:
Graph from: Yahoo finance, How Costly Is Reducing Inflation?
In the environment of strong interest rate hike signals and persistently high inflation, the downward pressure on the economy is significant. This is also reflected in the stock and bond markets. Based on general financial common sense, we know that bond prices and interest rates are inversely related. We tracked two representative bond ETFs: VCLT and MBB, representing corporate bonds and mortgage-backed bonds respectively.
We can find that the trend of these two ETFs is almost the same. Especially in 2022, the movement will be almost the same at each time period. Overall, VCLT is more volatile than MBB, rental market remains firm. We can very clearly see that both prices have fallen significantly since 2022, especially in March, April, and August. From the beginning of the year to the present, VCLT has fallen nearly 24%，the price of MBB has dropped about 10%. In the current economic environment, we believe that downside risks remain. The price decline of these bonds still has not bottomed out.
Based on the above analysis, we believe that the Fed will continue to maintain rate hikes until rates reach about 4.5%. The Fed will not adopt a policy of sharp rate hikes, but it will make the duration of continued rate hikes longer. This could lead to the U.S. economy falling into recession in early 2023. Considering that the possible recession has the characteristics of persistent high inflation and corporate deleveraging, the duration of this recession may be longer. It is estimated that it could last around 1.5 years.
There are significant downside risks to the bond market in the near term, given that CPI exceeded expectations in August. We expect bond prices in general to continue to fall through the end of the year, and their prices could fluctuate over the next year as the Federal Reserve slows down its rate hikes in the future. We don’t see a halt or slowdown in rate hikes for at least 3 months.