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Markets in ‘thrall of the Fed’, overly hawkish on rates
“Learning to live with COVID will be the major theme of 2022,” according to Ken Leech, chief investment officer of leading fixed income manager Western Asset. But not necessarily in the way we think.
As the Omicron variant ravages Australia and other parts of the developed world, Leech highlights continuing travel restrictions and lower vaccination rates in large parts of the emerging world as potential tailwinds for the year ahead.
After more than two years of restrictions, Leech expects “large segments of the global population will emerge from being shut in — and the sources of both supply and demand will be largely increased.”
The US appears to be well ahead of the market in this regard, effectively having been open for business for months, despite virus challenges. The end of 2021 saw the long-awaited announcement that bond purchases would be tapering and quantitative easing, in place for over a decade, would be wound back to zero.
The result is that markets, as they tend to do, have priced-in the expected scenario as nearly certain. Leech says “the markets have taken the inflation bait as proof positive that an accelerated and persistent Federal Reserve tightening campaign is in the offing”. In fact, the market is currently pricing in six — yes six — 25 basis-point rate hikes before the end of 2021.
Naturally the result of such a bullish (or “hawkish” in central-bank-speak) outlook is that the US dollar has rallied, and along with China’s regulatory crackdown and slowing economy, sent emerging markets into a tailspin. Putting political events and risk aside, emerging markets may well be offering significant value today, particularly in fixed-income markets, and especially if the ‘consensus’ on US rates is wrong.
With investors now positioned for expected elevated inflation prints, Leech suggests markets are in “thrall of the Fed” saying that “while that path is not implausible, should that level of fear (around rate hikes) really constitute the base case?”
Western’s house view is that growth will remain “firm,” albeit at lower levels, and that “Chinese policymakers will begin to stimulate in very short order,” with the latter already in play.
“Currently, the real yield differential between EM and DM rates stands at 15-year wides. As the global recovery blossoms and Covid recedes as a frontline worry, EM economies and currencies should rapidly recover” he says.
