Quarterly Outlook
Equity outlook: The high cost of global fragmentation for US portfolios
Charu Chanana
Chief Investment Strategist
The Federal Reserve is cornered between a possible taper or inflation tantrum
Althea Spinozzi
Head of Fixed Income Strategy
Summary: We believe that it will be nearly impossible for the Federal Reserve to avoid a tantrum in credit markets. If the central bank doesn’t do enough to fight inflation, markets will face the possibility of an inflation tantrum. However, we might face a taper tantrum if it is too aggressive in tightening the economy. The recent acceleration in real yields, the spike in the MOVE index, and the widening of the HY-IG spread indicate we might not be far from a widespread selloff in credit markets. We recommend investors remain cautious as we approach the March FOMC meeting.
It has arrived the time to consider the possibility of an upcoming tantrum in credit markets.
Since the beginning of the year, junk has overperformed quality as interest rate risk eroded value faster than credit risk. Bonds with higher duration, hence better-rated credits, have dropped in value faster than bonds with lesser duration. Triple C credits lost only -3.29% year-to-date, while investment-grade bonds fell nearly double.
However, credit risk perception might change as monetary policies become more aggressive, and financing conditions tighten fast.
The Fed’s posture is clear: inflation needs fighting. According to markets, that will be possible only through an aggressive interest rate hiking schedule, possibly combined with a balance sheet runoff. It means that interest rates will continue to rise, contributing to a capital loss in older bonds as prices fall below par. At the same time, we’ll see the issuance of new bonds with bigger coupons in the primary market. The faster that happens, the bigger the tantrum.
High inflation makes a key difference compared to the macroeconomic backdrop during the 2013 taper tantrum. Inflation is a threat to the bond market as it erodes the present value of fixed coupon and redemption payments. Therefore, the central bank needs to hike rates to avoid an inflation tantrum. However, suppose the central bank does too little to fight inflation. In that case, bonds will lack protection against it, and markets will need to raise their future rate hike bets, creating the conditions for a selloff. Yet, if the Fed is too aggressive in tightening the economy, it might result in a taper tantrum anyway. Thus, the Federal Reserve is walking a fine line, and a tantrum is nearly inevitable as monetary policy can be too much or too little aggressive at markets’ discretion.
Real yields are one of the best tools to forecast a tantrum. As the central banks prepare for a tightening cycle, nominal yields will inevitably surge, while breakeven rates will adjust lower, accelerating the rise of real yields.
One can argue that real yields remain in deeply negative territory, leaving financing conditions still highly loose. However, that was also the case in 2013, but things started to go south as real yields accelerated their rise to 0%. We could say that the 2013 taper tantrum was all due to an acceleration in real yields.
Now that real yields rose above -0.5% and the probability of a 50bps rate hike in March is growing, it’s inevitable not to forecast an acceleration in real yields around the Fed’s March meeting. Such a rate hike is likely to tighten financing conditions quickly and it might provoke a tantrum within risky assets as it happened in 2013.
Other elements suggest we might not be too far off from a tantrum. On Tuesday, the MOVE Index rose to the second-highest level since the 2013 taper tantrum and the highest since the beginning of the Covid pandemic. The move index is the “fear index” for the bond market, like the VIX index is for equities. During the 2013 Taper Tantrum, it peaked at 117, while now it's shy of 100.
Another helpful metric to look at is the spread between high-yield and investment-grade corporate bonds. Despite the spread between the two remains low compared to pre-pandemic levels, it has widened substantially since the beginning of the year. If the spread continues to widen, it would be an indication that investors start to reconsider credit risk, as they would sell junk to buy high-grade corporates.
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