Douglas Rissing
Stronger U.S. economic data is leading to speculation the U.S. Federal Reserve may be ready to pivot away from its current strategy of aggressive rate hikes. Greg Bonnell speaks with Robert Pemberton, Head of Fixed Income at TD Asset Management, who says deviation by the Fed likely won’t be happening any time soon.
Transcript
Greg Bonnell: Stronger US economic data has led some market watchers to believe that a Fed pivot away from jumbo-sized interest rates could be on the way. But is that actually the case? Joining us now to discuss is today’s featured guest, Robert Pemberton, Head of Fixed Income at TD Asset Management. Robert, great to have you here.
This is the big question of the summer, really. You get one inflation print that comes in a little bit below expectations, pivot, pivot, pivot. What’s the reality here?
Robert Pemberton: Well, great to be here. And it is the teeter-totter that everybody’s talking about right now, the seesaw battle between inflation and growth. And the way I would basically characterize it is one number does not make a trend. We saw yesterday from the Canadian statistics CPI coming in on a headline basis lower but core inflation continuing to rise.
And what the Fed, Bank of Canada, Bank of England, the ECB are all focused on now is inflation and targeting that lower inflation growth. And my current read on it is that if you were going to call anything a pivot in the last Fed announcement, it would be a pivot from the end of the beginning to the beginning of the end of Fed rate hikes. And that pivot is still in the process. And we’re a long way from being done on the rate hike side.
Greg Bonnell: I was going to say, beginning of the end sounds like a bit of a long road. I think we’ve become accustomed to really quick responses and getting our needs met very quickly by central banks. And it’s been a while, always riding to the rescue.
But this seems to be an era where they’re saying, listen, we’ve got an inflationary problem here. And we’re going to do whatever it takes. And that sort of reads to me as restoring some credibility that may have been lost earlier in the pandemic.
Robert Pemberton: Well, certainly with the responses we saw both from a monetary perspective and a fiscal perspective during the pandemic, the economic growth we saw coming out of it definitely saw central banks behind the times with respect to inflation and inflationary pressures. And I’m certain when economic historians look back at this period, they will say that the central banks were slow to react.
The reaction function since then has actually been very, very positive in terms of gaining back much of that credibility. And we’ve seen that both from where we see terminal rates – so what the market’s pricing for where central banks will get to – as well as what we’re starting to see from an inflation perspective.
My thought process on it right now is that we’re likely to see inflation move lower relatively quickly to probably that 4 and 1/2% to 5% range. But from 5 and 1/2% – or 5%, rather, down to 2% could be a much longer slug than the market’s currently pricing.
Greg Bonnell: Let’s talk about the long game, then, because obviously there had been some thought, not only from a pivot point of view, but even this fact that they’re going to be done pretty soon. And then they’re going to be cutting again because they’re going to have to react to weakness in the economy. And some people say, not so quick.
The inflation job and bringing it down to target is going to be a rough one. It is going to be a long one. And you just can’t turn on a dime again and get back into easy monetary policy. We’re not going to get all of our needs met in the next couple of days or weeks.
Robert Pemberton: Correct. And I think maybe a good way to frame that is people expecting the Fed put to come back into the marketplace are likely to be disappointed over the next two or three years. We certainly believe that the market is mispricing the rate cuts in ’23 and ’24 in order to get inflation back down.
Certainly, some of the cyclical components of inflation are going to come back down and ease. But some of the secular issues associated with it, particularly wages, housing, owner’s equivalent rent, things along those lines – they are going to remain sticky and higher for longer, which tends to mean that overall inflation will remain higher.
And with that, as I mentioned, the idea that the Fed will be cutting rates in 2023 is, in my opinion, a little misplaced at this stage. I think the market is trying to bet between which former Fed governor they’re going to – or Fed chairman, rather, they’re going to have, whether it’s going to be the Arthur Burns of the mid-1970s or whether it’s going to be Paul Volcker of the 1980s.
Arthur Burns, from a historical perspective, was reluctant to raise rates meaningfully to quell inflation, whereas we know Paul Volcker had a great deal of credibility when it comes to raising rates and dealing with the tough medicine upfront in order to provide a better outcome for the economy longer term.
Greg Bonnell: Well, these divergent views in the market right now, this push and pull and people trying to figure out exactly where they want to be – what does it mean for the fixed-income space? How should we approach it as an investor?
Robert Pemberton: Well, from our perspective, some key things have happened, the idea that we’ve seen an aggressive hike early on in this cycle. And we continue to believe that we’ll see 50s or 75s going forward for the next couple.
Central bankers broadly in North America want to get to at least 3 and 1/2% on an overnight basis, which, clearly, we’re 100 basis points away from. So we’re going to continue to see that. But from a fixed-income perspective, what that means is we’re likely to see more volatility, partly because we’re going to see more volatility in both the inflation numbers in economic growth and in assets, broadly speaking.
And we’re also going to see greater volatility in the numbers as a result of the Fed dropping forward guidance. So today’s numbers in retail sales, yesterday’s numbers in CPI, housing data, employment data – all of that is going to drive market outcomes, which means we’re likely to see a broader range, particularly at the front end of the yield curve, as investors are trying to price 50 or 75.
To me, that’s kind of picking at nits. It’s going to be at least 50. And it might be 75 depending on what the data shows us. But volatility will be higher. Interesting thing, though – longer-term maturities in the bond market are likely to experience somewhat less volatility simply because so much has already been priced in for central bank cuts.
And a way to think about long-term yields is they are a series of short-term yields and with the idea that break-evens in the RRB market or in the TIPS market continue to point to long-term control of inflation. We believe that the longer end of the yield curve is likely to behave better than the front end of the yield curve, which is why you’re seeing the inversion of the yield curve, where short-term yields to maturity are higher than longer-term yield to maturities.
And that’s really under the basis that central banks are going to have to act aggressively initially. But over the longer term, we’re likely to see things moderate back towards more a 2 and 1/2% overnight range. But that’s several years out.
Greg Bonnell: For some people, that inversion of the yield curve is not a good sign for what’s coming ahead in the economy. People always want to say, this time it is different. Is it different this time? Or is this giving us a pretty dire warning sign?
Robert Pemberton: I don’t know if I’d use the word “dire.” But inversion in the yield curve generally means that there will be some economic pain ahead. The two-year, 10-year curve is inverted. The one that I’m really more focused on is three months, 10 years.
And it still remains positive at the margin. But it has not inverted yet. I expect it to invert before the end of the year, which really points to an economic slowing in 2023, 2024. And as a reminder to our viewers, the central bank has a very blunt tool with monetary policy. And what they’re looking to do is decrease demand in the economy overall. And if they’re going to do that, there will be slowing.
It’s just, will it be a painful slowing, or will it be more moderate and softer? And I think there are different definitions of how to think about that. There’s going to be a requirement for some unemployment increases in order to take some of the pressure off the labor markets. There’s going to be a need for final demand to decrease across multiple services. So they’re trying to engineer that.
And an analogy I used in a conversation not too long ago about this would be the central bank’s trying to land a C-130 Hercules cargo plane on a postage stamp. So it’ll be a tough one to achieve a very soft landing. And it’s certainly something that they’re looking at trying. We think that the probabilities of a recession are greater than 50% over the next 12 to 18 months.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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