Expect Market Volatility Ahead
The Federal Reserve has been walking a fine line between lagging employment and elevated inflation readings. The June FOMC meeting came in more hawkish than expected as the Fed was forced to acknowledge that inflation has indeed caught them by surprise.
The Summary of Economy Projections, a compilation of Fed member forecasts, surprised the market by pulling forward rate hike expectations. The projections now expect two hikes to the Fed Funds rate in 2023 compared to zero in the March projection.
Federal Reserve Dot Plot
Source: Smith Capital Investors, Federal Reserve, 6/16/21
Fed Chair Powell attempted to stick with the “transitory” inflation narrative in his press conference, though acknowledged that the moves have been larger than anticipated AND the timing of when those increases will fade is uncertain as are the effects over time. Given this environment, they are prepared to adjust policy if the increase from inflation proves to be more than transitory.
Regarding tapering asset purchases, Powell also said that we should take this meeting as the official “talking about talking about tapering” and each meeting going forward is live. He noted that most committee members do believe we will make economic progress faster than expected, and he agreed that would be a welcome development, but commented we are not yet at “substantial further progress”.
The initial market reaction saw Treasuries sell-off, however, the follow through post meeting registered a massive curve flattening as the front-end moved higher in yield on the expectations of a change in Fed policy while the long-end was pricing in policy error, rallying Thursday and Friday post meeting.
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U.S. Treasury Curve
Source: Smith Capital Investors, Bloomberg 6/18/21
Previously, Treasuries had consolidated and sat in a range for close to 16 weeks, but this Fed action was finally the catalyst for breaking out. The market digested the new information over the weekend and reversed price action once again on Monday. Treasuries sold-off led by the 30-yr. Between the moves last week and the sell-off Monday, the takeaway is that volatility is increasing once again which makes every economic data point and Fed meeting or communication a market moving event.
30-yr U.S. Treasury Intra-Day
Source: Smith Capital Investors, Bloomberg 6/22/21
While this acceleration of potential Fed Funds hikes has impacted Treasury valuations, we believe another large unknown of Fed policy – the timing of any asset purchase tapering – has just as much potential to impact valuations across fixed income assets.
Earlier this month, the Fed announced the unwind of the Secondary Market Corporate Credit Facility. This facility purchased corporate bonds and ETFs. The overall impact of this was minimal as the amount of assets the Fed owned (~$13bn) was minuscule compared to the broader market. However, as it relates to the Treasury and MBS markets it can be argued that given the size of purchases, the Fed has been the primary driver of valuations for both asset classes.
This is most apparent in MBS as we have witnessed MBS underperform versus its duration adjusted benchmark by almost 100 bps in the last three months. In the beginning of the year, we saw Fed purchases of MBS drive valuation levels to a point where the Fed was the only remaining buyer. As the market has slowly started to incorporate the idea of the Fed reducing its purchase activity in the MBS market, the OAS of the MBS market moved almost 25 bps wider, driving the significant underperformance. Future updates on Fed purchase activity have the potential to continue this trend as MBS spreads remain below their historical ranges.
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Bloomberg Barclays U.S. MBS Index Option Adjusted Spread
Source: Bloomberg 6/18/21
We have reached the point in the recovery where the Federal Reserve can begin to dial back accommodation and with that, we expect to see heightened market volatility around economic data reports as well as Fed meetings and communications. Beyond the timing of future Fed Fund hikes, any announcements surrounding reductions in the asset purchase programs for Treasuries and/or MBS have the potential to impact valuations across the fixed income market.
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