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November 3, 2022

Thomas Garretson, CFA
Senior Portfolio Strategist
Fixed Income Strategies
Portfolio Advisory Group – U.S.

In the run-up to the final two major global central bank meetings this week featuring the Federal Reserve and the Bank of England (BoE), an air of dovishness floated over markets – first led by the Bank of Canada, which delivered a lower-than-expected 50 basis point (bps) rate hike on Oct. 26. That was followed by the European Central Bank the next day where policymakers delivered a second 75 bps hike but signaled a reluctance to state explicitly that more increases are in the pipeline, while raising doubts about the need to take policy rates much beyond the “neutral” level and into economically restrictive territory, despite still-elevated inflationary pressures.

And that set the stage for the latest Fed meeting this week where markets expected the Fed to follow suit with a long-awaited dovish pivot away from jumbo-sized rate hikes. It actually played out largely in line with consensus expectations – with the meeting confirming that after a fourth consecutive 75 bps rate hike, the pace would likely slow “as soon as the next meeting” in December, according to Fed Chair Jerome Powell during his press conference. But moments later he once again stamped down any sense that the Fed was at all ready to back down from its fight against inflation.

After an initial positive market response to the policy statement, something Powell apparently caught wind of as he went on to deliver some of his most hawkish statements, sending equity indexes down sharply, and Treasury yields higher.

Of particular note was that while the pace of hikes may well slow, the level of rates ultimately needed could be “higher than previously thought,” a level thought to be 4.75 percent as recently as the Fed’s mid-September meeting. Powell cited recent data on the labour market and inflation that have yet to show any real signs that the 375 bps of total policy tightening over the past nine months – the most over any similar window since 1980 – has actually had much of any impact at all. As the chart shows, the process of discovering how high rates need to go has been a process indeed – from a peak level of 2.75 percent at the March meeting, 3.75 percent in June, and 4.75 percent in September. It seems to us that the Fed still has no real sense of what that terminal level is, and that’s only adding uncertainty and volatility to U.S. markets.

The Fed’s expectations for where it’s ultimately taking interest rates continue to shift higher

The Fed's projected peak level of interest rates this
        cycle

Line chart showing the Fed's projected peak level of interest rates this cycle has continued to shift higher over the course of the year, from just 2.75% as of the March FOMC meeting, to 4.75% when the Fed last provided updated economic projections. Fed Chair Powell signaled that that level may be even higher now, causing RBC Capital Markets to raise its terminal rate level to 5.25% by March 2023.

  • Fed funds rate
  • RBC Capital Markets forecast
  • Fed's terminal rate projection

Source - RBC Wealth Management, Bloomberg, RBC Capital Markets, Federal Reserve Summary of Economic Projections

So as a result of the Fed digging in its heels and offering few reasons to doubt its resolve, RBC Capital Markets raised its peak policy rate forecast to 5.25 percent, from 4.75 percent, which it sees being achieved by March of 2023 via a series of 50, 50, and 25 bps rate hikes in December, February, and March, respectively.

Higher for shorter

To this point, the broad sense has been that the Fed would take rates to a high level – but perhaps not excessively high – and then leave them there for an extended period of time as a hoped-for “soft landing” played out. But in our view, the risk is only growing that the Fed is going to simply keep at it until something breaks, and that higher rates will mean a faster policy reversal as prospects of a “hard landing” for the economy grow. As the saying goes, the bigger they are, the harder they fall.

And the Fed seems … okay with this? Also from Powell’s press conference, he clearly remains in the camp that sees the risks of doing too little as outweighing the risks of doing too much, stating “… if we were to overtighten, we could then use our tools strongly to support the economy. Whereas, if we don’t get inflation under control because we don’t tighten enough, now we’re in a situation where inflation is now entrenched …” This essentially means that if the Fed gets it wrong, it could simply start cutting rates.

A tale of two countries

Whereas the Fed continues to be unwilling to give markets even an inch by warning that rates could go higher than expected, the BoE took a different tack by stating that if policy rates did indeed rise as high as markets had been expecting – north of five percent in 2023 – a two-year long recession could be the result.

So though the BoE delivered a 75 bps rate hike, the biggest in over 30 years, by pushing back firmly against the market it has set a firmly dovish tone, with the pound falling nearly two percent against the dollar in the aftermath of its meeting. That puts dollar strength – which has already caused global stress – back on the radar as the Fed now stands alone.

Narrow seas, wide opportunities

While Powell noted that the path to a soft economic landing was “narrowing,” we believe the opportunities for fixed income investors as a result of aggressive central bank rate hikes have only widened. As the chart shows, yields on aggregate investment-grade bond indexes around the globe are nearing multi-decade highs. But as Powell also noted, the Fed could be forced to reverse course just as quickly as it set out, which means the window for investors to put money to work at historically attractive levels may also close sooner than some may expect.

Global central bank tightening has brought bond yields back to near 20-year highs

Line chart showing as global central banks have moved aggressively in 2022 to raise short-term policy rates, yield on offer from global investment-grade aggregate bond indexes are approaching some of the highest levels of the past decade as the Bloomberg US Treasury Aggregate Index now yields 4.4%, the U.S. Aggregate Bond Index yields 5.0%, and the Global Aggregate Ex-US Bond Index yields 2.7%.

  • U.S. recession
  • Bloomberg US Treasury Aggregate Index yield
  • US Aggregate Bond Index yield
  • Global Aggregate ex-US Bond Index yield

Source - RBC Wealth Management, Bloomberg bond indexes


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Thomas Garretson, CFA

Senior Portfolio Strategist
Fixed Income Strategies
Portfolio Advisory Group – U.S.