The Year of the Hawk?

This month’s main article, The Year of the Hawk, addresses the definitively hawkish pivot of the Fed, and the potential implications of rising rates on the investment environment.

Also included are the following themes:

• Credit Vista: Containers and trucks and trains - oh ABS!

• Trading Vista: It's really time
  

The Year of the Hawk?

Jon Schwartz, Senior Portfolio Manager

Late last year the Federal Reserve got off its perch and made a definitive hawkish pivot to a less accommodative policy. The bond market has certainly taken note, and 2022 has started off with a major repricing of interest rate expectations. Does it confirm that this is the year of the hawk? Although it is looking that way, the final answer will be determined — as ever — by the data.

The December employment data showed continued job growth, even though the headline number missed, with 199,000 jobs added vs. expectations for 450,000. However, the unemployment rate still fell from 4.2% to 3.9%, with the labor force participation rate improving from 61.8% to 61.9%. This move toward “full employment” did nothing to dissuade the Fed from using its two main tools to slow the deteriorating purchasing power of the dollar. The Fed began moving away from quantitative easing (QE) and then started moving toward a policy of quantitative tightening (QT) by allowing US Treasuries and Mortgage-Backed Securities (MBS) on its balance sheet to mature without being reinvested. This is known as runoff, and by capping the runoff, the Fed can control how fast or slow it reduces the size of its balance sheet. Depending on the pace of this runoff, the impact on economic conditions can be similar to that of fed funds rate hikes, which is the Fed’s other primary tool to control inflation. Both tools are clearly in play for the new, more hawkish policy.

It’s Different This Time

As always, it is helpful to look back at prior cycles to understand what may happen in the future. The last time the Fed began hiking interest rates was in late 2015, when it raised the fed funds rate 25 basis points (bps) from zero, then waited until the end of 2016 to hike another 25 bps. The Fed then hiked three more times in 25-bps increments in 2017, bringing the fed funds rate to 1%. It was at this point, four rate hikes into the hiking cycle in September 2017, the Fed instituted caps on the number of US Treasuries and MBS it would allow to mature each month. The caps the Fed instituted on balance sheet runoff started at $10 billion and grew to $50 billion after one year.

Source: Bloomberg. Data as of January 26, 2022.

One major distinction between now and 2017 is the state of the economy. Inflation is much higher today than it was at any point in 2017, and the unemployment rate is lower. The Fed’s balance sheet is also significantly larger in comparison with 2017. This all points to the need to accelerate the reduction of the balance sheet and increase the pace of rate hikes compared to the prior cycle. Runoff caps in the $100 billion range are certainly on the table, which would reduce the size of the Fed’s balance sheet by $2.4 trillion after just 24 months of QT. It remains uncertain when QT would begin, but reducing the size of the Fed’s balance sheet by June or July is certainly on the table.

As investors, we want to not only consider the dollar amounts and the pace of QT, but also the details of how the Fed intends to reduce its balance sheet. Recent QE programs enabled the Fed to buy both US Treasuries and MBS. Treasury purchases keep interest rates lower on the yield curve to support lending and the flow of capital, while MBS helps support the housing markets directly by keeping mortgage rates low. Given how hot the housing market was in 2021, the Fed could easily choose to accelerate MBS runoff to cool off the housing market.

Poised for Higher Rates

In addition to more runoff, it is plausible for the Fed to be more aggressive with raising the fed funds rate, especially given the current economic dynamics. As we discussed earlier, job creation continues to improve, and we are approaching what the Fed considers “full employment.” Wages are rising at an estimated rate of 6% year-over-year (YoY), which is keeping the pressure on labor markets. The pandemic continues to create supply chain bottlenecks, especially across Asia where zero-COVID policies are prevalent, prolonging price dislocations in the durable goods sector. Commodity prices, home price appreciation, and rent growth are also weighing heavily on inflation expectations. These factors are red flags for the Fed, and if inflation stays high, it is quite plausible the Fed will be forced to raise the fed funds rate more than four times this year, which is what the market is pricing in today.

Chairman Powell has stated “we are in no way bound to the playbook of the last cycle.” As with any Fed expectation, investors believe the ultimate path of QT will be data dependent, especially given the volatility seen in markets that began in 2022. So while many are concerned about rising rates, it is also important to remember the interest rate markets are likely to present a much better investment environment than we have seen in the last two years. We believe the year of the hawk is setting us up well to take advantage of rising rates to maximize income for client investment portfolios in a risk-measured way.

Credit Vista: Containers and trucks and trains - oh ABS!

Tim Lee, CFA, Senior Credit Research Advisor

With the recent COVID-19 Omicron variant disrupting the start of a new year, the supply chain problems that some thought would wane seem like they will persist throughout 2022. Robust demand for physical goods, combined with pandemic-related production constraints and inadequate transportation capacity, continues to push prices higher. Both pundits and policy experts are concerned prices may not moderate anytime soon. Perhaps the chief worrywart is the Fed, which is adopting a more hawkish policy stance and may begin hiking interest rates as soon as March.

Credit investors, however, should not feel shaken by the higher prices and inventory issues caused by supply chain problems. In fact, many investors could benefit from exposure to the transportation segment of the supply chain through asset-backed securities (ABS) collateralized by equipment, such as containers, trains and trucks.

With travel, entertainment and other services curtailed by the pandemic, many people have engaged in retail therapy, buying an array of physical goods ranging from furniture to frozen food. All this has increased the demand for shipping containers. As a result, container prices have climbed significantly. Container-backed ABS data from S&P Global Ratings show utilization rates near 100%. All this has fueled the recent excellent credit performance of container ABS.

Figure 1

Source: S&P Financial Services, SVB Asset Management. Data as of January 26, 2022.

Similarly, ABS that include truck leases have also exhibited excellent credit performance. Truck utilization rates have been at full capacity, as the increased volume of containers requires more trucks to transport all those containers to warehouses and other supply chain points. While truck utilization is projected to normalize by 2023, the low inventories of trucks should help keep truck pricing steady and further support credit fundamentals of container-backed ABS.

Figure 2

Source: FTR Associates, Bloomberg, SVB Asset Management. Data as of January 26, 2022.

Figure 3

Source: FTR Associates, Bloomberg, SVB Asset Management. Data as of January 26, 2022.

With containers and trucks near maximum capacity, it is no surprise that rail transport has also been pressed into full service. Boxcar and railcar utilization rates have climbed to near capacity.

Figure 4

Source: GATX Corporation, Bloomberg, SVB Asset Management. Data as of January 26, 2022.

Demand for railcars and boxcars is expected to remain at high levels, thanks not only to current consumption, but also for the need to restock inventories. Just in the second half of 2021, the average lease renewal term jumped 27% (37 months vs. 29 months), according to data by GATX, a major lessor. The longer lease term and improving lease pricing illustrates the market’s belief that railcar utilization will remain near full capacity for the near future. This should generate a steady stream of cash — a credit positive for investors of railcar-backed ABS.

Figure 5

Source: GATX Corporation, Bloomberg, SVB Asset Management. Data as of January 26, 2022.

The positive fundamentals of railcars, trucks and containers contributed to the stellar credit performance of equipment ABS during the pandemic, which was evidenced by a 23% upgrade rate (and zero downgrades). The upgrade rate for equipment ABS was nine points higher than the 14% upgrade rate of all US ABS.

With supply chain challenges set to persist to a significant extent through 2022, we also expect favorable credit fundamentals will remain in play for container, truck and railcar ABS. All this translates into potentially attractive opportunities for credit investors.

Figure 6


*Twelve-month upgrade rate for the period from July 1, 2020, to June 30, 2021, for US ABS rated by Moody’s Investor Service.
Source: Moody’s Investor Service, Bloomberg, SVB Asset Management. Data as of October 26, 2021.

Trading Vista: It's really time

Jason Graveley, Senior Fixed Income Trader

The rates market is off to a torrid pace this year, as a more hawkish shift in Fed rate expectations has caused a sharp repricing across the Treasury curve. If we focus on the moves at the beginning of the year, the 2-year Treasury Note, considered to be the most sensitive to shifts in monetary policy, has risen close to 30 bps at its January peak. The 3-year Treasury Note saw a similar shift, moving from 95 bps to 136 bps. Fed Chairman Jerome Powell recently validated the market’s expectations, acknowledging that “it’s really time” for rate normalization in 2022. This reinforced the market’s projection that the Fed will deliver a rate hike as early as March and quite possibly continue quarterly throughout the year at the subsequent June, September and December meetings. While the effort to counter the recent inflation surge continues to dictate policy change, the path of future rate hikes will depend on the persistence of supply-side disruptions and how quickly fiscal stimulus fades.

This upward shift in benchmark rates has buoyed overall market yields, which have moved higher to reflect a faster pace of rate increases. Money market instruments have repriced, although the increase has largely been attributed to rate volatility and not credit spreads. The Bloomberg Barclays Credit Indexes, both those under the 1-year and the 1- to 3-year mark, have tightened month-over-month (MoM). Investor demand has not waned in the front-end investment-grade space, where cash has been parked short while rate volatility persists and the path forward clarifies. However, we would not be surprised if the demand side of the equation shifts as the year progresses, with investors’ preferences pushing the yield curve out farther as some slope returns. This could result in drawdowns for both money market balances and the Fed’s Reverse Repo facility, both of which hit all-time highs ahead of year-end.

On the supply side, bill issuance is expected to increase this quarter by $200 billion, as the Treasury regrows its cash balance, while the corporate new-issue run rate should remain flat YoY. However, there has been an uptick in issuance, as the Fed is on the cusp of raising interest rates, particularly among financials. Over three trading sessions in January, five of the six major banks brought $28.75 billion in new debt. This resulted in higher new-issue concessions (four times the 2021 average) and only about 60% of investor participation, compared to previous deals. Year-to-date (YTD), banks have accounted for $80 billion of supply, and even before month-end this volume had made it the second-largest January on record.

We remain vigilant with wider spreads taking shape in the belly of the curve and some steepness returning. We can see that any prolonged shift in investor sentiment away from their recent short preference would pressure front-end spreads higher. As such, portfolio positioning and retaining a money market fund allocation should allow us to take advantage of any pricing dislocations should these expectations occur.

Source: Bloomberg, Silicon Valley Bank as of 1/31/22.