No pivot from the FED and a ramp up in Quantitative Tightening

Powell signals no pivot in sight

With the Jackson Hole Economic Symposium over, bond and equity markets have been left scrambling to predict the Fed’s next moves in September and beyond. A hawkish Jerome Powell poured cold water over the market’s hopes of a “Fed Pivot” in the early months of 2023 and restated the FOMC’s commitment to win the fight against inflation with higher rates, for longer. 

Bond and equity markets reacted negatively to the news, with the prospects of a pivot seemingly reduced to zero, and the chances of a Fed-engineered “soft landing” quickly declining. Investment Grade Bond ETFs such as IG, LQD and ARCX:CORP all sold off on the news, and have been down between 0.5% -1.23% since August 29th. It is important to note that all 3 ETFs are down between 13%-16% YTD, with their lows of the year reached in mid-July.

Fixed income update in North America

U.S Treasury ETFs across the yield curve (SHY, IEI, IEF and TLT) were subject to the same market sell off however they fared slightly better, with initial sharp declines on August 29th in line with their Investment Grade counterparts, but outperforming them over the next 5 days by roughly 50 bps. 

North of the border, the Canadian economy is much less diversified and much more vulnerable when compared to the U.S, primarily due to the significantly higher Personal Debt levels. This characteristic has made its sensitivity to rate hikes quite different, with home prices across the country sharply lower from Q1 and further pain projected by analysts and economists. The Bank of Canada is widely expected to hike rates yet again in September, but market participants doubt it will be able to keep up with the pace of the Fed for the reasons mentioned above. The doubt in the BoC’s ability to raise in tandem with the Fed is reflected in the relative outperformance of various Canadian Bond ETFs (XSBN, XBB, ZFL, and XCB) over the last month, compared to the U.S counterparts mentioned above. 

Fixed income update in Europe

Across the pond in Europe, the Bank of England is struggling to contain runaway inflation resulting from exponentially higher Energy prices, with some projections expecting between 14%-22% inflation by the end of the year. Maintaining a similar tone, members of the ECB are strongly suggesting the hiking cycle will continue across the Eurozone, even in the face of risks to economic growth.

As of August 30th:

• The yield on 10-year Treasuries advanced two basis points to 3.12 percent
• Germany’s 10-year yield advanced three basis points to 1.54 percent
• Britain’s 10-year yield advanced 10 basis points to 2.80 percent

Quantitative Tightening - the other side of the coin

Monetary policy is not the Central Bank’s only tool in reducing inflation however, and the effects of Quantitative Tightening should not be ignored. 

It is expected that in September the Fed’s QT program will ramp up to its full potential, with an increase from its current $47.5 billion per month. Through this process, the Fed will allow MBS and Treasuries to roll off its balance sheet at a rate of $35billion and $60billion respectively, for a total of $95billion per month, and is expected to last for 2.5 years. This would result in a reduction to the Fed’s balance sheet of roughly $2.5 trillion, or 28%, and would bring its balance sheet back to levels seen at the beginning of 2021. As per a recent study conducted by the Federal Reserve Bank of Atlanta, the effects of QT would be equivalent to an additional 90bps increase in the Federal Funds Rate, albeit more gradually introduced over the next 3 years. 

Whereas interest hikes affect the short end of the yield curve, as has been seen by the dramatic increase in the 2-year yield, QT works on the long end of the curve and increases the 10- and 20-year yields, as mortgages with long-term maturities are allowed to roll off without replacement. 

Investors will be closely monitoring the economic data scheduled for release and will be looking for hints on the trajectory of the FED over the coming months. 

Please note this article is for information purposes only and does not constitute investment advice.