Befuddled guidance

Portfolio manager Oliver Blackbourn responds to the latest update from the US Federal Reserve as talk focuses on tapering and interest rate changes.

Key takeaways:

• The president of the Federal Reserve Bank of St Louis has connected the end of quantitative easing to the earliest that interest rates could be hiked.
• The Fed’s ‘dot plot’, showing projections for the federal funds rate, indicate that interest rates could rise twice in 2023.
• The real yields on US Treasuries have bounced over the last month, although they remain very close to all-time lows.

Even the US Federal Reserve (Fed) does not seem to know what link there should be between quantitative easing and interest rates. At Jackson Hole, Chair Powell tried to explicitly separate tapering and when US interest rates may start rising, but James Bullard seems to have skipped that particular slot at the conference. The president of the Federal Reserve Bank of St Louis again connected the end of quantitative easing to the earliest that interest rates could be hiked. Markets could be forgiven for being confused by the differing communications, but clearly there is a difference of opinion inside the world’s foremost central bank as to the implications of any policy changes.

Bullard’s comments also illustrated one of the ways that the Fed could still deliver a hawkish surprise in a couple of weeks’ time if it announces a rapid taper plan. Bullard indicated that he would like to see asset purchases wound down by the end of the first quarter 2022; that would be a quick six-month taper at presumably $20 billion per month. This would probably be quicker than many investors have assumed, given the Fed’s reluctance so far to begin the process of reducing stimulus, despite the surge in both realised and forecast inflation.

There is also another factor that could lead to market consternation – the Fed’s notorious dot plot, showing projections for the federal funds rate. The median estimates currently indicate that interest rates could rise twice in 2023, but it would not take too many changes for forecasts to show a hike by the end of 2022 and a commensurately higher 2023 figure. The upcoming dot plot is also due to show the first iteration of estimates for the end of 2024. Markets are only pricing four to five hikes between now and then, with a couple already indicated by the previous dot plot. However, this leaves scope for a hawkish surprise if Federal Open Market Committee (FOMC) members believe that a hiking cycle could be fully underway.

Nominal US Treasury yields have found a little upward momentum since early August, in line with the longer-term trend. Breakeven rates have trended sideways since early June as investors look for a peak in the inflation surge and then indications of where it will start to settle, but the real yields (adjusted for inflation) on US Treasuries have bounced over the last month, although they remain very close to all-time lows. A move higher in real yields has the potential to affect many assets across the spectrum, given the influence on the US dollar and broader valuations.

Breakeven inflation rate: represents a measure of expected inflation derived from 10-Year Treasury Securities.