How High? For How Long?

Three questions have characterized the Fed’s tightening program since it started: How fast will the fed funds rate rise? How high will it get? And for how long will it stay high? In 2022, the Fed answered the first question increasing the funds rate by 425 basis points over 9 months, by far the fastest tightening cycle since the interest rate targeting era began. Regarding the second and third questions, the fourth quarter of 2022 (4Q22) showed that policy makers and investors have some disagreements. While investors expect the funds rate to peak just below 5% in mid-2023, and possibly a Fed cut by the end of 2023, Chairman Jerome Powell reaffirms the Fed’s commitment to price stability; stating that rates could further increase and stay at restrictive levels until there is convincing evidence that inflation is returning to its long-term 2% target.

Recent inflation reports influenced investors’ views. In 4Q22, inflation surprised markets on the downside twice, a deviation from seven upside surprises between January and September. The downward surprises loosened financial conditions early in 4Q22 (for example, the S&P 500 gained 14% in October-November), prompting Fed officials to reassert their hawkish policy stance. The following lines from the December Federal Open Market Committee (FOMC) meeting minutes² capture the dynamic between investors and policymakers: “An unwarranted easing in financial conditions, especially if driven by a misperception by the public of the committee’s reaction function, would complicate the committee’s effort to restore price stability.” This tension between investors and policy makers also reflects uncertainty about the persistence of above-target inflation and whether the economy will enter a recession.

Market Update

During the quarter, the real yield curve rallied, falling more than 30 basis points near 5-year maturities. Investors drove the rally as they extrapolated from two consecutive downward surprises in inflation that the Fed might soon pause. But as Exhibit I shows, the Fed’s hawkish stance pushed rates higher in December. Ultimately, the great tightening of 2022 lifted short-term real yields by more than 400 basis points, and long-term rates by more than 200 basis points. The 10-year real rate went from -1.10% at the end of 2021 to 1.57% at the end of 2022, the highest annual increase on record. Real rate volatility increased to an average of 8 basis points in 2022 from a daily average of 4 basis points before 2022. As a result, we see improved Treasury Inflation Protected Securities (TIPS) valuations and more opportunities ahead for the asset class.

During the quarter, TIPS returned 2%, bringing returns for the full year to -11.8%, ahead of nominal Treasuries by 60 basis points. Given the magnitude of rate increases in 2022, the 7.7% inflation TIPS accrued in the year was crucial to their outperformance over nominal Treasuries. Flows into TIPS-related Exchange-Traded Funds (ETF) tend to follow TIPS absolute returns; in 2022, the asset class experienced a net outflow of more than $12 billion, a significant yet small share of the more than $50 billion that went into TIPS ETFs in 2020 and 2021 combined.

The decline in commodities and energy prices that started in the summer brought down market-implied inflation expectations (breakevens), especially near short maturities. As a result, the breakeven curve is no longer inverted. Although breakevens increased in 4Q22; for the year, they fell about 90 basis points and 30 basis points near 2- and 10-year maturities, respectively. It is important to note longer-term breakevens remained anchored throughout the current inflationary process (see Exhibit II). By the end of 2022, investors expected inflation to grow at an average 2.4% between 2023 and 2027, and at an average of 2.2% between 2028 and 2032.

Performance and Positioning

Our TIPS portfolios outperformed the benchmark in 2022. Our strategies that are based on seasonal patterns, term structure and TIPS auction cycle contributed to performance. In accounts with futures authority, our breakeven position added to performance as well. Fed tightening kept our term structure allocation slightly behind the benchmark for most of 2022, but after real yields sold off, valuations improved, and we positioned our portfolios with a slight overweight.

Inflation and the Economy

As of December 2022, annual headline Consumer Price Index (CPI) inflation reached 6.4%, and core CPI reached 5.7%. It is useful to group core inflation into goods (26% of core CPI), shelter services (41%), and services excluding shelter (33%). Exhibit III shows that goods prices moderated as supply chains eased and post-pandemic demand shifted to services. Shelter services, which grew 7.5%, drove core inflation in 2022. Inflation continues to run at a fast pace, but there are signs it will decelerate over the coming months. For instance, the Zillow Rent Index, a private sector indicator of rental costs, leads shelter CPI by almost 12 months. This indicator peaked in early 2022 and was almost flat by November. Finally, services excluding shelter presents persistence risks given its dependence on the labor market. Wage growth remains above 6%, and even as the Fed raised rates by more than 400 basis points, the labor market refused to ease. In 2022, the labor market added more than 4.5 million jobs, lowering unemployment to the pre-pandemic low of 3.5%.

Financial markets appear priced for an economic slowdown and corresponding Fed easing. For instance, the 3-month to 10-year slope of the Treasuries yield curve, a well-known recession indicator, is inverted at -50 basis points, implying a 60% probability of recession in the next 12 months by our estimates. The fed funds futures market shows the policy rate peaking at just below 5% in mid-2023 and trending downwards for the rest of the year. Furthermore, as mentioned above, inflation markets are pricing near-target inflation rates.

One wrinkle in the market story is that economic fundamentals are not in recession territory. A weekly measure of economic activity published by the New York Fed stabilized recently, at a low level, but is still consistent with positive economic growth (see Exhibit IV). The 3-month moving average of the Chicago Fed National Activity Index is flat, a level consistent with long-term trend growth, and above the recession threshold of -0.7. Moreover, a popular indicator that has correctly identified every recession since 1960, developed by former Fed analyst Claudia Sahm, is currently at zero. The Sahm rule signals the start of a recession when the three-month moving average of the national unemployment rate rises by 0.5% or more relative to its low during the previous 12 months (see Exhibit V).

Conclusion

Inflation has come down from its 9.1% peak and is expected to decelerate further, but a return to the Fed’s 2% target is far from assured. While the labor market remains tight and wages grow at high rates, there is a possibility that inflation stays above target for longer than expected. We believe markets are not pricing enough inflation, presenting good opportunities to outperform nominal Treasuries going forward. As real yields normalized following the extreme volatility of 2022, TIPS valuations improved substantially. We believe it is a good time for investors to increase allocations to TIPS.