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July 2021 | GSAM Connect

Fed Messaging Affirms Pro-Cyclical View

Desk Note: Views from the Model Portfolio Management Team

  • In an unexpected twist, the Fed acknowledged growing confidence in the unfolding economic expansion cycle, despite the need for further progress on labor market recovery
  • Inflation risks at the margin have tilted slightly to the upside
  • We feel that the Fed’s latest update further validates our bullish pro-cyclical reflationary portfolio positioning

The Federal Reserve (Fed) surprised investors following the conclusion of the Federal Open Market Committee (FOMC) meeting on June 16. The surprise was essentially two-fold. First, Chairman Jay Powell stated, “You can think of this meeting that we had as the talking about talking about meeting.” This contrasted the Fed’s longstanding narrative dating back a year-ago when Powell stated that the Fed wasn’t even thinking about thinking about tightening monetary policy. This advanced the timetable relative to prior consensus thinking in the market that the Fed would likely wait at least until the August Jackson Hole Fed conference to unveil potentially market-moving forward looking policy guidance. The second part of the surprise was how the majority of FOMC participants now see the Fed increasing policy interest rates in 2023, with nearly half now believing that policy rate liftoff may be necessary in 2022.

Investor reaction to the Fed’s surprising shift in rhetoric was notable. The S&P 500 Index declined for a couple of days by about 1.7% but then regained the entire selloff in the week following the conclusion of the FOMC meeting. The timing of the Fed’s unanticipated hawkish tilt touched multiple asset classes. The U.S. dollar firmed in the currency market, commodity prices generally fell, and the Treasury yield curve flattened.

The reaction in the bond market is what we found to be most thought-provoking. Considering that the Fed acknowledged the pace and strength of the recovery from the pandemic-induced recession and how transitory inflation pressures have surprised on the upside, it is the manner of the resulting yield curve flattening that is most curious. In the week following the June 16 FOMC meeting, relative to the prior day’s closing Treasury yields, the 2Y T-note yield increased 9 basis points (bps), the 5Y T-note yield increased by 8bps, but the 10Y Note and 30Y T-Bond yields declined by 3bps and 10bps respectively (June 15 vs June 22, closing nominal constant maturity yields).

Much of the post-FOMC market reaction appears to be position-adjustment in nature. Given the Fed’s longstanding policy-on-hold, interest rates-lower-for-longer stance, investors have generally been leaning toward short-duration fixed income exposures in anticipation of a steepening yield curve as the expansion cycle gained traction resulting in progress toward the Fed’s two percent average core inflation policy objective. The continuity surrounding this consensus macro market view was interrupted by the Fed’s shift to a more hawkish narrative. Evidence of the magnitude of the Fed surprise is seen in the fact that the degree and speed of the curve flattening witnessed between the 30Y and 5Y Treasury yields (known in the industry as 5s30s) equated to well in excess of a three standard deviation weekly market event. The exhibit on the next page, titled “Histogram of 5s30s Weekly Moves,” shows how remarkable this 3.4 standard deviation (or “sigma”) flattening move is, as compared to more typically observed weekly moves.

Exhibit: Histogram of 5S30S Weekly Moves (Last 10Y)

Source: Goldman Sachs Investment Strategy Group, as of 6/21/21

For our part we are encouraged by the latest development in Fed rhetoric and forward looking policy guidance since it actually falls in line with our expectations for sustained economic expansion, giving rise to improving corporate profitability, and our ongoing expectation that bond yields will continue to adjust higher in a predominantly non-disruptive orderly fashion. Because of this view, we generally favor more cyclically oriented equities, such as small caps and overseas markets, as well as inflation protected securities and shorter duration fixed income exposures.



Source: Multi-Asset Solutions as of June 2021. There is no guarantee that these objectives will be met. Past performance does not guarantee future results, which may vary. The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this presentation.

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