Higher for Longer

The House of Representatives passed a more than $1 trillion bipartisan infrastructure bill, sending it to President Biden for his signature. The measure, already approved in the Senate, marks the first milestone of President Biden’s heavy economic agenda. 13 Republicans voted in favor for the bill while six Democrats voted against it. The bill authorizes current spending and commits $550 billion in new spending to improve roads, bridges, highways, overhaul the electric grid, and other such projects. Electric vehicle stocks may be a beneficiary of the Infrastructure Investment and Jobs Act with $7.5 billion slotted for electric charging stations. The larger Build Back Better bill has yet to be passed.

The United States is about to lift its nearly 20-month international travel ban. International visitors from more than 30 countries will now be able to visit the U.S.; however, there will be new rules that replace the ban, including requiring international visitors to show proof of vaccination and a recent negative Covid test. One major airline reported that it expects 50% more international inbound passengers from a week earlier as the restrictions ease. Airfare tracking site Hopper has said that international flights searches have more than quadrupled since the Administration said in September that it would lift the ban.

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A few years ago, the buzz on Wall Street was “lower for longer,” with many investors expecting global bond yields to remain low for the indefinite future. Now, investors are essentially talking about “higher for longer,” with some investors expecting inflation to remain elevated and persistent. This should in theory lead to significantly higher interest rates and yet the 10-year U.S. Treasury yield is at just 1.48%. While the bond market may be predicting a Fed liftoff (or first rate hike) by mid-to-late 2022 (see figure 1), it does not appear to be aggressively pricing in future growth and inflation. We largely agree with the Fed and expect inflation to moderate in 2022. However, it may take some time for supply bottlenecks and price pressures to ease as exporters work to replenish inventories and for consumer demand to normalize post-covid fiscal stimulus.

This line chart shows the number of Fed rate hikes expected by September 2022. Markets are pricing in at least one rate hike by September 2022.

Fed Chair Powell acknowledged this at the November Federal Open Market Committee (FOMC) meeting by saying, “Our baseline expectation is that supply bottlenecks and shortages will persist well into next year and elevated inflation as well. And that, as the pandemic subsides, supply chain bottlenecks will abate and job growth will move back up. And as that happens, inflation will decline from today’s elevated levels. The timing of that is highly uncertain, but certainly we should see inflation moving down by the second or third quarter.” It is a bit odd to use both “highly uncertain” and “certainly” in the same sentence, but we think the key takeaway is that the Fed still believes that inflation is primarily linked to covid-related distortions and not a permanent condition that will require the Fed to act aggressively.

Apart from slight language changes, the Fed did exactly what the market expected it to do by announcing that it will start to taper its bond purchases by $15 billion a month which will be split between $10 billion in U.S. Treasuries and $5 billion of agency mortgage-backed securities. This move was widely telegraphed. As it stands now, the Fed is on track to end all bond purchases by mid-2022. However, the Fed did say that the current pace of reductions has only been ordered for November and December. That means that the pace could adjusted beyond that timeframe. This could mean that the Fed might stop reducing the pace of purchases should the economy show signs of weakness, but we think it is more likely meant to keep the door open should the Fed want to accelerate the wind down.

One reason the Fed may want to do this is to have more flexibility on interest rates come mid-summer should inflation not show signs of easing. Thus far, the Fed has expressed that it intends to remain patient when it comes to rate hikes, but Chair Powell did also say that the Fed will not hesitate to use its tools to fight inflation if it’s needed. Importantly, the Fed alone cannot solve supply bottlenecks, but it can cool consumer demand through higher interest rates if it is needed. We doubt that this is the most likely scenario, but it is possible if the Fed does eventually become convinced that it is indeed “behind the curve” on inflation.

At the end of the day, it is encouraging that the equity market took the Fed’s tapering announcement in stride, but the debate over the timing of the next rate hike is likely to remain a hot topic heading into 2022 with the market looking for four to five rate hikes by the end of 2023. In the meantime, the Fed continues to urge patience and says that the bar for rate hikes is substantially higher than that of tapering. It looks like the complex dance between market expectations and the Fed’s policy prescription will continue for some time. We should also highlight that Fed Chair Powell’s term is set to expire in February 2022. It seems like the odds favor his reappointment with betting market PredictIt.org putting the odds of Chair Powell being renominated at 79% and the odds of Fed Governor Leal Brainard being appointed at 22%, but there is always a chance that President Biden will decide to make his mark on the Fed. Current Fed Governor Randal Quarles has also stated that he intends to resign his position around the end of this year. In theory, potential changes to the Board’s composition could impact both market expectations and Fed policy.

Away from the Fed, the Labor Department reported that the U.S. economy added 531,000 jobs during the month of October. So far this year, monthly job gains have averaged 582,000 jobs so this report is pretty much right in line. If the economy continues this monthly pace of job gains, then the economy would be back to its pre-pandemic employment level by about June 2022 (see figure 2), which of course is when the Fed will most likely end its bond purchase program. The previous two months were also revised upward by 235,000 and the unemployment rate fell from 4.8% to 4.6%. All-in-all, the strong report supports the Fed’s decision to start tapering.

This line chart shows the U.S. Jobs Deficit Since February 2020. After a steep drop in March and April 2020, there has been a steady return to job positions filled. As of October 2021, there is still a deficit of 4.7 million jobs from February 2020.

Lastly, Citi Global Wealth’s Global Investment Committee decided to reduce its overweight to global equities from +8.0% to +6.0% and to reduce its underweight to fixed income and cash from -8.0% to -6.0%. There were several regional adjustments, but the overarching theme is that the Committee expect returns to moderate in 2022.

With U.S. bond markets now pricing in 4 to 5 rate hikes by the end of 2023, the valuations of intermediate-duration U.S. treasuries, investment grade corporate, and some municipal debt have improved and can be used as risk hedges, so the Committee added 1.0% to intermediate-duration Treasuries and U.S. investment grade. With cash at a -1.0% underweight, that puts the fixed income and cash portfolio weighting at -6.0%.

On the equities side, the Committee decided to slightly reduce its overweight to global equities by lowering the overweights to DM large cap Asia ex China by -0.5%, EM Asia ex China by 0.2%, UK large cap equities -0.3%, Europe ex UK ex Switzerland large cap by -0.2%, and global healthcare shares by -1.0%. This move acknowledges that the Chinese economy may slow in the quarters ahead, which could weigh on trade-linked regions and also a move towards less cyclical, higher quality assets as the initial reopening surge starts to normalized further.

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