The U.S. Federal Reserve announces plans to begin unwinding its bond-buying program amid a recent inflation surge. Anthony Okolie speaks with Scott Colbourne, Managing Director, TD Asset Management, about the Fed’s decision and the outlook for interest rates.
Good afternoon. Markets were really expecting three things, or focusing on three things. They're focusing on a taper. They were focusing on how the Fed would characterize inflation. And the third thing was any sense on a list off, that is any heads up on a rate hike. And so, to your question, the taper was as expected. So the Fed is going to taper starting this month, $15 billion. Ten of that is US treasuries, 5 in mortgage backed securities, and it's expected to conclude sometime in May of next year. But the Fed's given itself a little bit of flexibility in terms of either increasing or decreasing the taper depending on economic circumstances. Now, as far as inflation, it's really interesting. For the last number of meetings, basically the Fed has said, look, inflation is largely reflecting transitory factors. They've given themselves a little bit of wiggle room. It's hard to say what is, whether it's dovish or hawkish, but basically, they said, largely reflecting factors expected to be transitory. So they've introduced this element of hedging on the whole inflation debate because, as we know, since September, when they last did forecasts, employment has been good. We've had a little bit the employment cost index average hourly earnings are higher. So there is a sense in the market of slightly higher inflation. So they're marking the markets but still giving them some wiggle room. And certainly in the press conference on the last point, the Fed Governor Powell reiterated, look, tapering doesn't equal rate hikes and we have some ground to cover before we have rate hikes.
The last time the Fed tapered yields went down, the US dollar rallied and the S&P 500 went down 10%. Could we see the same thing happening this time?
I'm a little leery of just pulling out the old playbook. I do acknowledge how it played out the last time in 2013, 2014. Yes, the Fed announced it in December of '13 and concluded in '14 of October. But we first got our inclination about tapering in May of '13 and from May of '13 to the end of the year rates went up a whole percent. And then as tapering started and concluded, the rates rallied down. So look, I think it's more important to focus on the regime that we're in. The regime is slightly different than we found ourselves in the last environment. And I think it centers around inflation. And the previous taper would be described, perhaps as a Goldilocks environment, good growth, stable inflation. It was sort of in the range of 1.4 to 1.8% the whole time, pretty benign, in good earnings, obviously for the equity market. So this time around, it's the inflation environment that's slightly different. So be careful on sort of drawing a simple analogy. So I know I'm careful, and I still think that the trajectory on rates is slightly higher here in the bond market as we move through this this course, particularly as we really try to grapple with the uncertainty as far as inflation goes next year.
We've seen tremendous changes in global yield curves over the last two weeks. What are the global yield curves currently telling investors?
Well it really was a spectacular couple of weeks for bond investors to focus on and see what went on in these small, open economies like Australia, Canada, New Zealand, to a lesser extent, even the U.K. and Norway. We saw rapid repricing in the front end of the markets, short term rates. And in fact, in many of these markets, we saw three or four hikes priced in very short order. So what is it telling us and what do investors have to take from this? I think the way to interpret it is that the market has put forward those rate hikes that we thought about in 2023 and 2024. When we look at the shape of that short term yield curve, though, what's interesting is sort of what we call the terminal rate. Where do rates ultimately get to? And that hasn't moved a lot. So maybe the cycle is going to be short and sharp. Hikes focused in 2022 and then a petering out. Where do we get more bearish? Where do investors have to pay attention to is any sense that that terminal rate is moving higher? What could cause that? Higher inflation, a lot higher than we're expecting, or the central bank to get even more hawkish from here. So for the time being, it's been pulled forward and a stable outlook beyond that.
And how many rate hikes is a bond market pricing in at this point?
Well, it really depends on where you are. So today with the Fed, the markets are expecting two hikes next year, starting in July and another one in December. And even after today, it's largely as is. Rates have backed up a bit in the in the bond market in the US. You've got a lot more priced in around the globe. You could start with the far end with New Zealand at eight hikes between now and the end of next year. Canada is around six, five to six hikes. Basically the markets have listened to central banks, pushed back a little bit. But honestly, I think that what the market is hearing from the central bankers is, look, we're on our path, but you can do what you want to do. It gives us a little bit of insurance based on what might happen as far as inflation over the course of the next couple of quarters.
And what will you be watching closely for clues for directional momentum?
Well, we have in addition to today's Fed meeting, we have the employment data at the end of the week, and I think that's obviously important. Why? Because the Fed has two mandates. First mandate is inflation. Basically met the threshold there. And the second one is employment. We're obviously seeing a little bit of signs of wage inflation. Markets expecting 450,000 in jobs growth in the US this week. So that'll be the key for another directional move in the markets beyond today's Fed meeting.
And where did you see the US dollar going in the next little while?
Well, to handicap today's movements is often a little bit tough, but I would say that broadly speaking, there's a little bit of leaning into the end of the year to a slightly higher US dollar. Get a remarketing of rates in the US. A little bit of pressure higher. As we go into the end of the year liquidity dries up a little bit in the overnight market, in the funding markets, and so this will be a little bit support for the US dollar. That being said, still countries like Canada and Australia. You know, commodity environment is still positive, and that's a positive in terms of trade shock. So it's a bit of a mixed bag, depending on what country you're in. But broadly speaking, I think that here or slightly stronger is where I expect the US dollar to play out over the balance of the year.
And was there anything else that's notable that you heard today?
Look, I think the big thing for investors is to recognize that we're in an uncertain environment. We've had a lot of volatility as a bond investor. We've noted the volatility in the front end of the yield curve. Just bear in mind that the uncertainty associated with the inflation outlook is high. The Fed expects that it starts to unwind in the second quarter of next year, associated with all these COVID factors. So I think it's really important for investors to be mindful of the volatility that will be inherent in the markets over the next little while as we see liquidity slowly being unwound in the market as we wind down tapering over the next few quarters.
Scott, thank you very much for joining us.