Fixed Income: The Fed's Conundrum

"I believe the outlook is indeed for further volatility and the chances of a recession have increased dramatically."

Anybody a little confused? Four days ago, the US Treasury curve inverted with the 2s10s spread at -9.53bps intraday. That is what markets were pricing, a joint view of all participants in the most liquid market in the world. However, that sent signals that the Fed clearly did not like. Although market makers may have been right, only time will tell.

Governor Brainard, usually a dove, quickly stepped up, pointing out the market’s error, and the yield curve steepened with the 2s10s spread at +2bps. Moreover, following the Fed minutes release from the March meeting, the central bank’s Bullard joined in, pushing for a steeper yield curve and yields have once again re-priced with the 2s10s spread at +16bps, at time of writing. 2-year yields are currently trading at 2.52% while 10-years are at 2.68%.

So, the Fed is not only front-loading fund rate hikes, +50bps, +50bps, +50bps (?), announcing massive balance sheet adjustment, but is now looking to steepen the yield curve… wow.

Is the consumer that viable, is the economy that insulated? Arguably, 75%-80% of the drive of the US economy is consumption, so, does this strategy really work? Can economic activity keep going?

The Fed’s policy error started with the “transitionary inflation” statements. Anyone over the age of 50 years (and remembers the 80s) knows inflation is a sticky animal and could be transitory over nine months to a year, but in three months as per the Fed? Oops.

Now, months after inflation has taken a seat at the head of the table, here come the Fed, reminding us of 2018/19; it seems we have a repeat of errors. Back then the Fed worried about inflation from a tightening labour market perspective and wage inflation was not seen even though we moved to full employment. However, the Fed pushed yields higher for about 9 months in 2018. Commencing in October 2018 and ending in the Autumn of 2019, we witnessed the rally of all rallies in fixed income, and our funds returned around 18% in 2019 after ending 2018 slightly down on the year.

The best traders learn by mistakes. Has the Fed learned anything? The outlook is still confusing, but the Fed are “all eggs in one basket”. I, therefore, believe the outlook is indeed for further volatility and the chances of a recession have increased dramatically.

Freddie Coldham
Fund Manager, Fixed Income