Fed tightening is coming at a time of relative strength for the U.S. consumer. We look at what this means for fixed income investors.
May 26, 2022
By Atul Bhatia, CFA
The U.S. economy is consumption driven, with just under 70 percent of U.S. gross domestic product directly attributable to personal consumption. The next largest component—private domestic investment—is indirectly influenced by consumption trends, as business investment tends to ramp up and down to meet expected future demand.
By most measures, the U.S. consumer remains in good financial shape. Unemployment is near record low levels, average hourly earnings are at their highest levels in nominal terms, and with two job openings for every unemployed worker, prospects for continued wage strength appear robust. It’s true that wages have not been keeping pace with inflation, but if food or energy prices decline, workers may see meaningful increases in discretionary income.
Chart comparing the number of open jobs in the U.S. with the number of available workers to fill those jobs for the timeframe of December 2000 through March 2022. The chart shows job openings increasing by nearly 50% in the last 13 months to just under 12 million open jobs. This has resulted in the fewest available workers per job since data was first reported in 2000. Between 2000 and 2018 we consistently had more workers than jobs.
Source – RBC Wealth Management, Bloomberg; monthly data through 3/31/22
It would not be surprising to see some softening of demand as consumers react to inflation and higher interest rates. Recent retailer earnings reports, for instance, have shown some weakness as consumers reprioritize following higher food and fuel prices amid a broader shift from goods to services. Any future weakness, however, would be coming from a relatively strong level of consumer demand, a point that was underscored in both the April retail sales report and the Q1 GDP report.
Against this backdrop, it is somewhat surprising to see the litany of financial headlines portraying a near-term recession as inevitable. As we have highlighted in the past, while risks of recession are present and may increase in the following months none of the indicators in our recession scorecard indicate a likely near-term GDP contraction.
The recently released minutes of the Federal Reserve’s May policy meeting and recent Fed speeches laid out the Fed’s plan to move expeditiously to a neutral policy, where interest rates are neither adding to nor subtracting from underlying demand. The Fed’s stated belief, which we share, is that a faster removal of accommodation will allow the central bank to combat inflation with a lower final level of rates.
Investors appear receptive to this view, with market pricing as of May 25 reflecting a relatively rapid decline in inflation, even with less aggressive action from the Fed. Fixed income pricing shows a likely 2.9 percent inflation rate over the next five years, with a drop to approximately 2.55 percent annual inflation over the following five years. Both measures, respectively referred to as the 5-year breakeven and the 5y5y forward inflation rate, were down nearly 30 basis points in the month ending May 25. This decline in expected inflation comes despite markets seeing less aggressive Fed action compared to earlier this month, with futures markets now showing a likely 2.9 percent maximum policy rate this cycle compared to 3.3 percent in early May.
Line chart comparing the futures market expected level for overnight interest rates in March 2023 with market-derived measures of annual expected inflation over two consecutive five-year periods. The chart shows a significant decline in expected inflation in the past three months, a move that has increased even as futures markets see a lower policy rate.
Source – RBC Wealth Management, Bloomberg; daily data through 5/25/22
We see multiple reasons to justify the market’s confidence in the Fed’s ability to constrain inflation with a relatively low terminal rate. One is the possibility for additional supply, with increased overseas production, eventual reduction of supply chain bottlenecks, and a transition from goods to services demand. Another potentially supportive factor is the pre-pandemic labor market dynamic, which saw the U.S. economy operating comfortably with low unemployment and low inflation. Even a modest uptick in unemployment could allow a reassertion of employer bargaining strength, with concurrent downward pressure on wages and inflation.
One benefit the Fed has in its favor is that the required anti-inflationary tightening is coming at a time of strong household demand. Personal consumption was up 3.1 percent in Q1, according to recently released economic data, while overall domestic growth fell due to rising imports and shrinking government expenditures. This favorable baseline lessens the risks of a Fed overshoot, in our view.
In a scenario of moderating wages, moderating inflation, and moderating growth, we believe there are multiple potentially attractive investment opportunities. Equities, as we discussed in last week’s edition, may be well positioned for price gains over the medium term after recent pullbacks.
Corporate bonds are another asset class that could perform well if the economy muddles through, particularly if the Fed ends up hiking less than previously expected. Investment-grade bond indexes have fallen approximately 13 percent this year. The majority of the loss was a result of higher Treasury yields, although credit premiums also played a part. If the Fed is able to bring inflation down with a lower terminal fed funds rate, longer-maturity corporate bonds could perform well, potentially getting a boost from tighter credit spreads if growth is maintained. And of course, barring a credit event, bonds will return par at maturity.
Sub-investment-grade bonds, often referred to as high yield, are another asset class that could do well in a more benign economic environment. These issuers tend to be more sensitive to growth, with historical default rates well above investment-grade-rated issuers. This greater risk draws out higher average yields: the broad sub-investment-grade index is yielding roughly 7.5 percent while the highest-rated tranche, the BB sector, is yielding around six percent.
For many investors, corporate bonds fill an important portfolio niche. They provide exposure to economic conditions, but because the cash flows are stated in advance, the securities are typically less sensitive to overall earnings and cost pressures. As long as a company is making enough to comfortably pay interest and principal, the bond holder is typically satisfied.
Given the centrality of private consumption to the U.S. economy and the strength of recent economic data reports, we continue to believe that a near-term recession remains an unlikely event. In an environment of subdued, but still positive, economic growth, we believe corporate bonds are broadly well positioned to deliver expected cash flows and the recent pullback in prices provides what we consider to be attractive risk-adjusted yields.
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