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The Fed's 2022 Pivot: How Soon, How Fast

Volatility struck the bond market last week after hawkish comments from the Fed. Director of Short Duration Fixed Income Peter Yi examines the market reaction and longer term impact.

  • The Fed’s Waning Patience
  • How Investors Reacted
  • A Long-Term View on a Quick Pivot

 

Transcript

[MUSIC PLAYING] Federal Reserve Chairman Jerome Powell sparked market volatility last week when he said supply demand imbalances are likely to persist longer than originally expected, and the Fed must be humble and nimble where a rate hike may soon be warranted. This suggests continued elevated inflation, bolstering some investor views that the Fed will aggressively increase rates multiple times throughout the year. But we aren't so sure. Let's take a closer look.

At the press conference after the Federal Open Market Committee meeting, Powell emphasized a very different transition to higher rates than in the prior cycle of rate hikes. While COVID-19 variants remain a risk to economic growth, the Fed sees elevated inflation overshadowing that risk. Persistently high inflation could also threaten the labor market over time from taking away the benefits of wage increases, so the Fed believes it has little room to be patient about increasing rates.

On Powell's comments, short and intermediate-term yields rose the most, close to 13 basis points, and flattened the yield curve. Investors appeared to focus on the narrative of sooner and faster rate hikes from the Fed. In fact, one of our risk cases to our investment thesis is that the Fed makes a policy mistake where rate hikes go beyond investor expectations. However, we don't believe Powell's message was nearly as hawkish as the market interpreted.

We expect the Fed to implement its first rate hike in the March meeting, but more likely, 25 basis points rather than the more aggressive 50 basis points some have suggested. We also believe the Fed will start reducing the size of its balance sheet in the middle of this year, but with the focus on allowing Treasury bills of up to one year in maturity.

That may reduce the potential negative impact of bond sales on the open market. With the Fed making a quick pivot, investors should expect short-term volatility. However, they should consider the longer-term view that we are likely to see downward pressure on inflation and growth expectations towards the end of the year, which could prompt the Fed to pause as market conditions evolve.

[MUSIC PLAYING]

Peter Yi portrait

Peter Yi, CFA

Director, Short Duration Fixed Income and Head of Taxable Credit Research
Peter Yi is director of short duration fixed income and head of taxable credit research for Northern Trust Asset Management.