ACTV - Managing Risk: How Geopolitical Concerns Could Impact Markets
2023-10-11 21:05:00 ET
Summary
- Assessing risk amid heightened geopolitical tensions.
- Fed officials say high bond yields may be helping in their inflation fight.
- Is there a risk that the Fed is overtightening?
The Israel-Gaza conflict has some investors assessing how to manage risk in the current market environment. Alexandra Gorewicz, Vice President & Director, Active Fixed Income, Portfolio Management at TD Asset Management, discusses the implications for fixed income investors.
Transcript
Greg Bonnell: Well, the conflict involving Israel and Hamas has some assessing how to manage risks in the current market. We also have bond yields sitting at around 16-year highs. So there's a lot going on.
For more on how to view these markets, joined now by Alexandra Gorwitz, vice president and director of active fixed income portfolio management at TD Asset Management. Alex, great to have you back on the program.
Alexandra Gorewicz: Thanks, Greg. Great to be here.
Greg Bonnell: All right, so heading into this weekend, you and I actually had a conversation about what should we be talking about. Obviously, bond yields at 16-year highs. We had a big risk event over the weekend, obviously, with the situation in the Middle East. You start putting all that all together, what do we need to be mindful of?
Alexandra Gorewicz: That there's a lot of uncertainty. And how we price that uncertainty is a big unknown, right? If we think about what happened in September with the huge rise in bond yields, and then we had jobs numbers come out, both in Canada and the US in early October, and is just showing a lot of resilience. This tightening of financial conditions, this tightening of monetary policy just doesn't seem to be having an impact on the real economy.
And so investors are saying, look, the future is really uncertain, and the things that I thought would happen by this point are not happening. The slowdown of the economy is not really coming through. So maybe we need to charge more risk premia for the uncertainty, and that's manifesting in higher bond yields, particularly at the long end of the yield curve, 10-year and 30-year government bonds.
Greg Bonnell: Now, when you see a geopolitical risk event of this magnitude, you do see the move into gold. You see the move into bonds. We saw that play out. But at the same time, we got some dovish comments from Fed speakers talking about that dramatic bond sell-off, the rise in rates and saying, well, maybe now -
Alexandra Gorewicz: Right.
Greg Bonnell: The bond market has done our work for us.
Alexandra Gorewicz: Correct. So you have these multiple narratives right now that are making it difficult to say with any kind of conviction what is actually driving these moves in markets. Obviously, the conflict in the Middle East is still very early - too soon to tell whether it becomes more of a regional conflict. If it does, I think that has the potential to generate a risk-off sentiment globally across financial markets, across asset classes.
But in the US specifically, those call it dovish comments that you were referring to when I said that bond yields have risen, that investors are demanding higher risk premium, or more yield to hold government bonds with longer durations, what Fed members are interpreting that to be is what we call the term premium. In other words, demanding more compensation for holding longer duration risk.
And for them, that does translate ultimately into a tightening of financial conditions or a tightening of credit conditions for the real economy, whether it's corporations that have been delaying issuing new debt or refinancing because they kept expecting interest rates to come down.
Or whether it's households that have delayed those home purchases in the expectation that mortgage rates would come down. Well, now that longer bond yields are higher, the probability of both of those segments of the economy seeing an alleviation from higher yields is a lot lower. And so from the Fed's perspective, that means that really the bond market, it's doing its work for them.
Greg Bonnell: So after a year and a half of aggressive central bank rate hikes and then a bond sell-off that pushed yields in the bond market to 16-year highs, are we at a point now where we could say perhaps we have over tightened? This has gone too far.
Alexandra Gorewicz: Even before this move in the last several weeks, one could have made the argument that there was already over tightening. And again, like I mentioned, you would never know that there was over tightening if you just looked at the labor market, although the details, even within the labor space, are not strong, per se. Headline numbers are strong, but not necessarily the details underneath them.
That said, when you think about the Fed and having to conduct monetary policy or any central bank and having to conduct monetary policy to address future conditions, one of the things that they latch on to a lot is this concept of, well, what is the appropriate policy rate in the long run for our economy to be in equilibrium?
And there's so many things that impact how our economy can grow. It could be population and demographic characteristics. It could be government policymaking. It could be geopolitical conflicts. It could be indebtedness, innovation. There's way too many factors to determine what that appropriate policy rate is.
But while some people say, well, that rate is probably higher today than it was before the pandemic, I think there would be very few who would say that rate should be higher than where it was, let's say, 40 years ago.
And the reason I latch on to that period of time is if you compare where the Fed policy rate is today relative to that abstract concept of a neutral rate, it's actually - the policy rate today is higher relative to that neutral rate than where we would have been 40 years ago.
That's really relevant because it could actually suggest that although, you know, the Fed's sitting at just under 6%, the policy settings may be a lot more restrictive today than where they were when the Fed policy rate was double digits back in the '80s.
So again, depends on how you think through policy, monetary policy settings. But one could make the argument that financial conditions, or rather the Fed policy tightening, is a lot more today than it would have been back -
Greg Bonnell: So clearly there's a lot going on. We mentioned jobs. Have we talked about inflation yet? There would have been a time where we would have led this discussion with inflation.
Alexandra Gorewicz: Correct.
Greg Bonnell: Obviously, headline has been coming down. It hasn't been a straight path. Do we get a sense now with everything that's happening in the economy with all the market reaction that perhaps inflation is returning to two? At some point, I mean, probably not tomorrow, but at some point.
Alexandra Gorewicz: Yeah, so if you ask bond investors, right - and we have various instruments in bond land that we could proxy what bond investors think about inflation - they haven't - they haven't been worried that inflation will be somehow persistently above the Fed's 2% target. And what we've seen actually over the last couple of weeks with rising bond yields, this was not driven by an increase in inflation expectations.
So for that narrative, that, oh, you know, somehow a strong labor market is going to feed into more persistent inflation, and then that's going to lead investors to demand higher bond yields. That's not what's driven interest rates higher. So it's funny that you said, like, we would have led with inflation. This has not been an inflation-driven move.
And in fact, even when we look at what the Fed did, right, they gave us their updated economic projections, everybody latched on to the fact that their growth forecast is higher, right - the soft landing narrative.
But what about the fact that they've actually reduced their inflation forecast for this year, and then more or less left it unchanged for the coming years where they're showing a gradual return to 2%.
The Fed clearly doesn't see the risks to inflation to be skewed to the upside anymore. Now it's either balanced, and if anything - and if I mentioned that the policy settings might actually be a lot more restrictive than where they were four decades ago, it's possible that there could be some downside surprises to inflation in the coming months and quarters.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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Managing Risk: How Geopolitical Concerns Could Impact Markets