Liontrust Asset Management: Market Reaction to Fed Statement Creates Opportunity
The Federal Reserve refrained from raising rates in yesterday’s policy announcement, but signaled both an end to asset purchases and a rate hike for March. No news there.
However, Fed Chairman Powell has not denied the possibility of interest rate hikes at every policy meeting this year. If that happens, it would be roughly double the increase expected by the market.
Needless to say, the impact so far has been to further weaken risk assets and continue the growth-to-value rotation. There are growing signs that the general market is worried about the possible extent of the action, with major stock indices slipping into negative territory since the start of the year.
Bond yields, especially those in the United States, have risen. Short-term yields are back around 18-month highs. After being bearish for most of this period, we are beginning to believe that we will see positive returns from the short end of the US market over the coming year and we are likely to shift our portfolios more towards this part of the market. Marlet.
5-year US Treasury yields hit around 1.7%. We wouldn’t call them cheap at this level, but while yields could still rise, we think any capital loss shouldn’t offset the income from these bonds. Additionally, the market has now priced in five 0.25% rate hikes this year, so the risk of an upward adjustment in rate expectations is much less than it was.
Although we return to short-dated US bonds, we still believe that long-dated bonds are too expensive. The Fed is expected to hike rates to 2.5% by the end of 2023, so having the 30-year yield well below that level is surprising. The market clearly thinks that short-term rate hikes may need to be reversed in the future if they threaten the economic recovery. We do not agree. We think the economy can handle higher rates and we need to prepare for “higher for longer”.
Although we think 30-year bonds are expensive, we think the market may take longer to rally to our thinking. We wouldn’t be shocked if yield curves flattened further or even inverted, with the 30-year yield falling below the 5-year yield. The US 5-year is currently yielding around 40 basis points more than the 30-year; about half of the long-term average. If yields continue to flatten or reverse, we might consider implementing “curve steepening”: shorting longer-dated bonds while going long on 5-year bonds.
Moving away from the United States, almost 4 increases are expected in the United Kingdom. We continue to avoid UK gilts and do not have many sterling corporate bonds. The UK market, taken in isolation, looks very vulnerable to aggressive rate hikes, especially in the wake of the US decision. We continue to recommend releasing gilts despite their terrible performance lately.
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Thursday, January 27, 2022, 1:29 PM