Show Transcript
The U.S. Fed is expected to hike rates at its next meeting, while also injecting funds into troubled financial firms. Greg Bonnell speaks with Alexandra Gorewicz, Portfolio Manager, Active Fixed Income at TD Asset Management, on what bond markets are telling us about the pathway forward.
Print Transcript
[AUDIO LOGO]
* It's been a volatile ride for markets in recent days. Investors are navigating concerns about the global financial sector and how the US Federal Reserve is going to react to the stresses that we're seeing in the system-- that rate decision coming tomorrow. So what is the fixed income market telling us about the path forward? Joining us now with her view, Alex Gorewicz, portfolio manager for Active Fixed Income at TD Asset Management. Alex, always great to have you back on the show.
* Thanks, Greg. Great to be here.
* And great in times like this because there's a lot going on. I know you're on top of all of it. Where do you want to begin? I mean, do you want to begin with what we've been seeing with some of these US regional banks, what the Fed going to make of all-- what the bond market? I'll let you take the lead.
* Oh, I wouldn't even know where to begin because, obviously, we've been hit in a number of different ways. But probably the first overarching theme that we can draw from the experience over the weekend and, really, over the last couple of weeks is that interest rate hikes that we've seen very aggressively delivered over the past 12 months by all central banks are starting to take effect.
And, obviously, they're taking effect probably in places that are catching many of us off guard. When things start to break, they always break in places that nobody really saw coming or very few saw coming. But we do know that financial conditions are tightening now, not just in financial markets, but also in the real economy, and that is because of the tightening that we've seen in monetary policy.
Now, what does this mean looking ahead? Well, this is where, now, central banks are caught between a rock and a hard place because inflation, although decelerating-- and we saw today's CPI print in Canada that inflation continues to decelerate-- is still elevated.
So you know what do you do if you're a central bank? Do you pay attention to the things that are breaking, or do you stick to your guns in some way on your inflation targeting mandate and maintain interest rates at these levels? A lot of unknowns.
* When you talk about the fact that the aggressive rate hikes we've seen, that we've discussed so many times on the program over the past year or so are starting to take effect, and you said that never takes effect in the way, I guess-- or at least the first area to take effect because we've been talking all along about, well, as borrowing costs go higher, then households spend less. And maybe the unemployment rate ticks up a little bit, and the consumer gets more cautious, and all those kind of things.
And not that we're not seeing some signs of that, but it's really the financial system stress to begin with. You talked about the Fed being in a hard place because Powell has to maintain the fight against inflation, try to bring it down. But, at the same time, he has to show his hand somehow for the financial system stresses. I mean, what does the central bank now do to try to keep everyone on a calm path?
* Yeah. So the question is, who's path needs to be calm here? So let me explain what I mean. There's no doubt that there were clear governance issues, for example, with SVB that led to, really, lack of proper asset liability management, and the mismatches that they had absolutely contributed to their downfall.
But what we do know is that, currently, this level of interest rates-- and if they go higher-- when I say interest rates, I mean the policy rates from the Fed-- if they go higher, they'll continue to actually put more pressure on the entire banking system, which is a little bit unintuitive. Usually, interest rates going higher is a good thing for banks.
But, in fact, what's happening now, because we are at the end of the cycle, or at least that's the perception by the broader, fixed-income investor base, is that it's forcing depositors to take their money out of banks and put them in money market funds, which are very attractive or yield well above what deposit rates are being offered by banks.
So the challenge here, from Powell's perspective is, well, if you don't hike, then the last 12 months that you've spent anchoring inflation expectations in the market and with consumers around your 2% target could be stressed. It could be challenged.
But then if you do hike, you possibly exert more pressure on deposits leaving the banking system. So it ends up being, again, a hard and a rock place situation. Now, I guess with all the measures that have been taken by the Fed and by the Treasury-- just let's say the collective policymaker suite, and not just in the US, obviously-- globally, particularly in Switzerland over the weekend around Credit Suisse-- all the measures that they've taken should instill financial stability or at least temporarily instill financial stability.
But it doesn't change the fact core inflation is running at 5.5% in the US. The Fed cannot pause here without creating some concerns that inflation could be stickier in the long run.
* I want to talk about what the bond market is now expecting because I felt like, as the Silicon Valley Bank and Signature Bank story were evolving, and that it became a Credit Suisse headline last week, the bond market's expectations for where Fed policy is going to go felt like it was changing by the minute. It was like, oh, no, it's going to be a whole.
No, it's going to be a hike. It's going to be a gentler hike. They're going to cut by the end of the year. What is the bond market saying at this moment since you left your desk about the situation?
* Well, it's funny-- all the different scenarios you mentioned about what might be expected from the Fed tomorrow. You could find company in any one of those scenarios. You could find someone who thinks they should cut tomorrow, someone who thinks they should pause tomorrow, someone who thinks they should hike tomorrow.
And the way-- I think the key message from the bond market is less about the constant changing of, are they hiking? Are they not hiking? And it's more the signal that's being sent around the fact that this is the end of the hiking cycle.
Even if you deliver another rate hike, even if you deliver a few more 25 basis points-rate hikes, we're closer to the end then we thought we were even a month ago. And you could see that from how the bond market reacted to the ECB last week. So the European Central Bank raised its policy rate by 50 basis points, and investors reacted with interest rates falling, not rising. And that's very classic behavior one year at the end of the cycle-- end of the hiking cycle.
* Of course, the question-- I might even be front running one of our audience members because we're probably going to get this question during the show. But if that's the context now, for people who are waiting for central banks to the point where they start cutting again, has that timeline been moved forward, pulled forward at all.
* So if you ask the bond market, the answer is yes. So the things that are changing by the minute, as you pointed out, is actually, when will the first rate cut come? And right now, for both Canada and the US, that first rate cut is expected at some point in-- call it June or July. It's not fully priced for June, kind of fully priced by July.
* By this summer.
* By this summer, yeah.
* When I was finally enjoying a tan on this pale skin.
* [LAUGHS] That's right-- In three to four months from now. And if you think about the fact that still another rate hike or two are expected from the Fed-- no more from Canada-- I mean, that's not very far away. And now the real question becomes, well, are they in a position where they can do that.
So I mentioned, for example, core inflation is running at 5.5%. What about unemployment? Employment is at multi-decade lows, which is obviously a great thing for the US economy. But the Fed has actually shown as recently as December in their economic projections that they thought unemployment would rise by a percent this year, but they still wouldn't cut interest rates.
So maybe that's the threshold that we should really be looking for. I think we're going to get updated economic projections on Wednesday-- tomorrow. I'm losing track of time.
* It's real quick.
* Yep. So we're going to get updated economic projections from them. But I think that threshold still stands that they're worried, with such a tight labor market, that inflation won't come back down to 2%. And, at the end of the day, they have to see to their mandate and try to use other tools in their toolkit to address financial stability concerns, which is what they've demonstrated that they're willing to do.
And that's just the long-winded way of saying, the rate cuts right now that have been priced in over the last week with all of the stresses emerging in the banking system globally are probably a little bit unwarranted, given the economic backdrop. Now that could change very quickly. But, at the moment, it's unlikely the Fed will cut by the summer.
[AUDIO LOGO]
[MUSIC PLAYING]
* It's been a volatile ride for markets in recent days. Investors are navigating concerns about the global financial sector and how the US Federal Reserve is going to react to the stresses that we're seeing in the system-- that rate decision coming tomorrow. So what is the fixed income market telling us about the path forward? Joining us now with her view, Alex Gorewicz, portfolio manager for Active Fixed Income at TD Asset Management. Alex, always great to have you back on the show.
* Thanks, Greg. Great to be here.
* And great in times like this because there's a lot going on. I know you're on top of all of it. Where do you want to begin? I mean, do you want to begin with what we've been seeing with some of these US regional banks, what the Fed going to make of all-- what the bond market? I'll let you take the lead.
* Oh, I wouldn't even know where to begin because, obviously, we've been hit in a number of different ways. But probably the first overarching theme that we can draw from the experience over the weekend and, really, over the last couple of weeks is that interest rate hikes that we've seen very aggressively delivered over the past 12 months by all central banks are starting to take effect.
And, obviously, they're taking effect probably in places that are catching many of us off guard. When things start to break, they always break in places that nobody really saw coming or very few saw coming. But we do know that financial conditions are tightening now, not just in financial markets, but also in the real economy, and that is because of the tightening that we've seen in monetary policy.
Now, what does this mean looking ahead? Well, this is where, now, central banks are caught between a rock and a hard place because inflation, although decelerating-- and we saw today's CPI print in Canada that inflation continues to decelerate-- is still elevated.
So you know what do you do if you're a central bank? Do you pay attention to the things that are breaking, or do you stick to your guns in some way on your inflation targeting mandate and maintain interest rates at these levels? A lot of unknowns.
* When you talk about the fact that the aggressive rate hikes we've seen, that we've discussed so many times on the program over the past year or so are starting to take effect, and you said that never takes effect in the way, I guess-- or at least the first area to take effect because we've been talking all along about, well, as borrowing costs go higher, then households spend less. And maybe the unemployment rate ticks up a little bit, and the consumer gets more cautious, and all those kind of things.
And not that we're not seeing some signs of that, but it's really the financial system stress to begin with. You talked about the Fed being in a hard place because Powell has to maintain the fight against inflation, try to bring it down. But, at the same time, he has to show his hand somehow for the financial system stresses. I mean, what does the central bank now do to try to keep everyone on a calm path?
* Yeah. So the question is, who's path needs to be calm here? So let me explain what I mean. There's no doubt that there were clear governance issues, for example, with SVB that led to, really, lack of proper asset liability management, and the mismatches that they had absolutely contributed to their downfall.
But what we do know is that, currently, this level of interest rates-- and if they go higher-- when I say interest rates, I mean the policy rates from the Fed-- if they go higher, they'll continue to actually put more pressure on the entire banking system, which is a little bit unintuitive. Usually, interest rates going higher is a good thing for banks.
But, in fact, what's happening now, because we are at the end of the cycle, or at least that's the perception by the broader, fixed-income investor base, is that it's forcing depositors to take their money out of banks and put them in money market funds, which are very attractive or yield well above what deposit rates are being offered by banks.
So the challenge here, from Powell's perspective is, well, if you don't hike, then the last 12 months that you've spent anchoring inflation expectations in the market and with consumers around your 2% target could be stressed. It could be challenged.
But then if you do hike, you possibly exert more pressure on deposits leaving the banking system. So it ends up being, again, a hard and a rock place situation. Now, I guess with all the measures that have been taken by the Fed and by the Treasury-- just let's say the collective policymaker suite, and not just in the US, obviously-- globally, particularly in Switzerland over the weekend around Credit Suisse-- all the measures that they've taken should instill financial stability or at least temporarily instill financial stability.
But it doesn't change the fact core inflation is running at 5.5% in the US. The Fed cannot pause here without creating some concerns that inflation could be stickier in the long run.
* I want to talk about what the bond market is now expecting because I felt like, as the Silicon Valley Bank and Signature Bank story were evolving, and that it became a Credit Suisse headline last week, the bond market's expectations for where Fed policy is going to go felt like it was changing by the minute. It was like, oh, no, it's going to be a whole.
No, it's going to be a hike. It's going to be a gentler hike. They're going to cut by the end of the year. What is the bond market saying at this moment since you left your desk about the situation?
* Well, it's funny-- all the different scenarios you mentioned about what might be expected from the Fed tomorrow. You could find company in any one of those scenarios. You could find someone who thinks they should cut tomorrow, someone who thinks they should pause tomorrow, someone who thinks they should hike tomorrow.
And the way-- I think the key message from the bond market is less about the constant changing of, are they hiking? Are they not hiking? And it's more the signal that's being sent around the fact that this is the end of the hiking cycle.
Even if you deliver another rate hike, even if you deliver a few more 25 basis points-rate hikes, we're closer to the end then we thought we were even a month ago. And you could see that from how the bond market reacted to the ECB last week. So the European Central Bank raised its policy rate by 50 basis points, and investors reacted with interest rates falling, not rising. And that's very classic behavior one year at the end of the cycle-- end of the hiking cycle.
* Of course, the question-- I might even be front running one of our audience members because we're probably going to get this question during the show. But if that's the context now, for people who are waiting for central banks to the point where they start cutting again, has that timeline been moved forward, pulled forward at all.
* So if you ask the bond market, the answer is yes. So the things that are changing by the minute, as you pointed out, is actually, when will the first rate cut come? And right now, for both Canada and the US, that first rate cut is expected at some point in-- call it June or July. It's not fully priced for June, kind of fully priced by July.
* By this summer.
* By this summer, yeah.
* When I was finally enjoying a tan on this pale skin.
* [LAUGHS] That's right-- In three to four months from now. And if you think about the fact that still another rate hike or two are expected from the Fed-- no more from Canada-- I mean, that's not very far away. And now the real question becomes, well, are they in a position where they can do that.
So I mentioned, for example, core inflation is running at 5.5%. What about unemployment? Employment is at multi-decade lows, which is obviously a great thing for the US economy. But the Fed has actually shown as recently as December in their economic projections that they thought unemployment would rise by a percent this year, but they still wouldn't cut interest rates.
So maybe that's the threshold that we should really be looking for. I think we're going to get updated economic projections on Wednesday-- tomorrow. I'm losing track of time.
* It's real quick.
* Yep. So we're going to get updated economic projections from them. But I think that threshold still stands that they're worried, with such a tight labor market, that inflation won't come back down to 2%. And, at the end of the day, they have to see to their mandate and try to use other tools in their toolkit to address financial stability concerns, which is what they've demonstrated that they're willing to do.
And that's just the long-winded way of saying, the rate cuts right now that have been priced in over the last week with all of the stresses emerging in the banking system globally are probably a little bit unwarranted, given the economic backdrop. Now that could change very quickly. But, at the moment, it's unlikely the Fed will cut by the summer.
[AUDIO LOGO]
[MUSIC PLAYING]
