On the Radar

City National Rochdale, | Dec. 16, 2021

FAQs on the Markets and Economy

Why is the Fed planning on speeding up its tapering of bond purchases?

Fed Chair Jerome Powell took a surprising change in his tone by turning more hawkish. The Fed is becoming more concerned with inflation, and Powell is joining a chorus of other Fed officials considering increasing the pace of the tapering of its bond purchases.

The pace of tapering, which the Fed approved at its November 3 meeting, reduces bond purchases by $15 billion per month, which would have ended its bond-buying program in June 2022. But, a new pace approved at their December 15th meeting sets a faster pace of $30 billion per month would end the program in March. The Fed will not begin to raise interest rates until it is done with its bond-buying program. This move allows the Fed to begin raising interest rates sooner than previously thought. The median number of interest rate hikes the Fed policymakers plan for 2022 is now three, just three months ago it was zero.

Strong consumer demand continues to collide with limited supply due to pandemic-related constraints, pushing prices upward.

The consumer price index stands at 6.8% y-o-y, and now marks six consecutive months above 5.0%. Price pressures continue to be focused on goods rather than services (chart). A limited amount of goods are available, due heavily to COVID-19-related reduction in manufacturing and transportation. At the same time, demand for many of those items has picked up due to generous actions by the Federal Reserve Bank and the current and past administrations. The inflation rate of services has been more stable, due mainly to the excess capacity.

We expect the annual inflation rate to increase in the coming months as low monthly inflation numbers drop off the yearly calculation and will be replaced by more moderate gains. After that, the yearly change in inflation should begin to subside next year, as the supply/demand imbalance comes back into balance.

Renewed concerns over COVID-19, as well as the Fed's path of tapering, have brought volatility back to the market with the S&P 500 recently seeing its worst two-day performance in over a year and the VIX above 30 for the first time since February. Nevertheless, the pullback has been short-lived with stocks again trading near record highs.

While uncertainty around the path and virulence of Omicron remains, early data seems to indicate the variant is less severe than originally expected. Moreover, medical advances and vaccination progress have better prepared the health system to deal with another virus wave, and we would expect any disruptions to economic activity to be less severe going forward.

Markets are also closely watching actions by policymakers, with the Fed expected to announce the acceleration of balance-sheet tapering. Nonetheless, we continue to believe the Fed still has room to be patient and deliberate when it comes to rate hikes, the true measure of economic tightening. Equities historically have held up well during tapering and the start of Fed rate hikes.

Currently, investors have more questions than answers, and a more balanced landscape of risks raises the prospect of further volatility in the coming months and even a potential market correction. However, investors should also remember that short-term volatility is normal. Market declines do occur each year, but more often than not annual returns are positive. Indeed, despite recent volatility, the S&P 500 is up 25% YTD.

We also believe this bull market still has room to run and that the combination of sustained economic expansion, robust earnings growth and low interest rates will ultimately remain a tailwind for stock prices through 2022. Given this, investors may want to use any weakness ahead as an opportunity to add to core positions.

The pace of US high yield defaults has slowed significantly compared to a year ago, falling from nearly 9% in August 2020 to a six-year low of 2.1% in October 2021. The recovery has been driven by waning COVID-19 shocks and improving macroeconomic conditions, as well as funding conditions that remain accommodative despite the Federal Reserve’s increasingly hawkish tone.

On the corporate level, numerous borrowers refinanced outstanding debt during the pandemic, reducing their interest burden and extending maturities. This has provided significant breathing room for issuers despite recent supply chain disruptions, labor shortages, nagging inflationary pressures and lingering pandemic-driven headwinds.

Looking ahead, many on the street expect credit conditions to continue to improve, driven by easing supply constraints and labor shortages, further vaccine distribution and a gradual normalization in monetary policy. Both Moody’s and S&P expect US high yield default rates to bottom near 1.5% before increasing to roughly 2.5% in the second half of the year, which is still well below pre-pandemic levels of +/-4%.

High yield corporate bond yields have compressed more than 420 basis points as credit conditions improved, driving significant outperformance YTD against duration-matched Treasury (+6.4%) and investment-grade corporate (+5.8%) benchmarks. There is little discussion around the consistent underperformance of passive high yield strategies vs. active fund peers. Turnover costs are high in the high yield market, and we estimate that costs passive funds an additional 1% per year. Over 10 years, HYG* has underperformed its benchmark by almost 10%. We believe deploying high yield in a separately managed account, targeting specific bonds, is the best way to gain exposure.

Stay Informed.

Get our Insight delivered straight to your inbox.

Important Disclosures

Index Definitions

The Standard and Poor's 500 (S&P 500) is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States.

Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

There are inherent risks with equity investing. These include, but are not limited to, stock market, manager, or investment style risks. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices.

Investing in international markets carries risks such as currency fluctuation, regulatory risks, and economic and political instability.

There are inherent risks with fixed income investing. These may include, but are not limited to, interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond risks. When interest rates rise, bond prices fall. This risk is heightened with investments in longer-duration fixed income securities and during periods when prevailing interest rates are low or negative.

Investing involves risk, including the loss of principal.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.

Past performance is no guarantee of future performance.

This material is available to advisory and sub-advised clients, as well as financial professionals working with City National Rochdale, a registered investment advisor and a wholly-owned subsidiary of City National Bank. City National Bank provides investment management services through its sub-advisory relationship with City National Rochdale.

Put our insights to work for you.

If you have a client with more than $1 million in investable assets and want to find out about the benefits of our intelligently personalized portfolio management, speak with an investment consultant near you today.

If you’re a high-net-worth client who’s interested in adding an experienced investment manager to your financial team, learn more about working with us here.