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Fed policy: ‘Powell is trying to turn the battleship around,’ strategist says

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Tom Graff, Head of Fixed Income at Brown Advisory, joins Yahoo Finance to discuss the outlook for Fed tapering, the possibility of an interest rate hike in the first half of 2022, and how Fed policy could influence the stock and bond markets.

Video transcript

BRIAN SOZZI: Traders are closely watching the 10-year yield, which has trended higher out of the gate this week with stock markets back in rally mode. Will the move continue?

Tom Graff is the head of fixed income at Brown Advisory and joins us now. Tom, always nice to see you.

I'll put that question to you. Where do yields go here in the short term?

TOM GRAFF: Well, thanks for having me. I think interest-rate investors should be cautious. There's a lot more room for interest rates to keep rising. And while there's a lot of global demand for bonds, the US is one of the highest-yielding markets in the world. That could keep a lid on interest rates in the short term. I think over the course of 2022, it's very likely interest rates are going to be higher.

BRIAN CHEUNG: Hey, Tom, can you explain a little bit more of that thesis? And what's been interesting is the Fed commentary as of late that suggests maybe they could be a little bit more aggressive in tightening the spigot on its easy-money policies. How do you think the signaling that we've gotten from Jay Powell just over the last two weeks kind of plays into that call?

TOM GRAFF: Well, I think Powell is trying to turn the battleship around from being as dovish as he could possibly be to readying markets for the possibility of a hike in the first half of 2022. There's really no reason for Powell to signal a faster QE tapering as he did over the weekend or over the past week other than to ready some optionality to hike as soon as April. I think that the idea that inflation may be transitory could still turn out to be the case, but there's been enough data that has the Fed nervous enough that they need that option to hike even sooner.

BRIAN CHEUNG: Now, Tom, at the same time, this is enormously consequential because it's not like people are just putting bets into fed funds futures markets. I mean, you can see in the credit market, for example, a lot of companies trying to pull forward issuance, which has really increased the supply of specifically investment-grade debt. We know it's been a very healthy market in 2021 for corporate issuers, even those that are rated junk. Do you feel like the pulling forward of supply here is a bit premature given the track record of Fed watchers and the Fed itself being wrong on the timing of liftoff? Does this look like the Ravens trying to make that 2-point conversion this weekend?

TOM GRAFF: Well, that's a low blow there, Brian.

BRIAN CHEUNG: I'm sorry.

TOM GRAFF: No, look, I thank, you know, for companies thinking about their own situation and taking a bird in hand, if you will, knowing that interest rates are low now and spreads are tight now and the markets are wide open now and go ahead and issue the bonds when you can. That's been sort of the MO of companies for the last few years, not just recently. So I think that part makes sense.

But I do think if I were a banker advising a company, I would say the same thing. Like, maybe interest rates won't be higher, but they're not going to be a lot lower, and so sort of get while the getting's good makes sense to me.

JULIE HYMAN: Hey, Tom, it's Julie here. Rates have not really moved, right? Especially the longer end have not really moved on this perception that the Fed is going to move. What is going to change that? Is it just a matter of proximity and getting closer to the Fed's actual increasing of rates or are there other dynamics in the market here that are influencing that?

TOM GRAFF: Yeah, that's a great question. I think the dominant dynamic is this view that while the Fed wants to-- or may be forced to hike rates to respond to inflation in early/mid 2022 that they won't be able to lift off a far way from zero before it causes damage to the economic growth.

And if that were to be the case, then longer-term interest rates are probably pretty fair where they are. In other words, if the Fed only gets to 1% or 1 and 1/4% or even 1 and 1/2% and then the economy weakens thereafter, then longer-term interest rates make perfect sense. I think there's a lot of bets that way.

In a sense, it's very similar to how things played out in the end of 2018 when the Fed had hiked to about 2 and 1/4% and then was signaling they were going to keep going. There was a big equity riot, and then the Fed backed off. I think that there's a lot of-- there's a lot of players who think that'll replay in 2022 into '23.

Now, I'm more optimistic than that. I think the economy is on better footing, and I don't think that just a few rate hikes are going to make us go into tight money, but I think that is the dynamic. So if you ask, well, what could change that? I think it's going to need time, Julie. I think it's going to need proof that the economy is indeed that strong.

JULIE HYMAN: And, Tom, sort of connect the dots for our viewers for a second here because what I hear you talking about is a taper tantrum, right, like you were referring to at the end of 2018 where stocks went down, but how does that then feed through and cause potential damage to the actual economy?

TOM GRAFF: Well, you know, interest rates affect everything. So it affects from-- we mentioned earlier companies borrowing. It affects valuations on stocks, which is what we wind up talking a lot about in these kinds of forums. But it also affects people's ability to buy a home, people's ability to buy a car, even people's desire to spend versus save. And so there's just a lot of effects that changes in short-term interest rates can reverberate through the whole economy. You may remember that past Fed chairs have called monetary policy a bazooka, and I think that's why because it can make such a big deal.

So I think viewers should consider that there is some point at which interest rates are high enough that money becomes tight and that becomes problematic. I merely don't think we're that close to that number and that interest rates can rise a good bit from here.

BRIAN CHEUNG: And then, Tom, I want to ask about just any sort of other factors that could be playing in here. It's never wise to have one single narrative for any movement, especially in the liquid market for US Treasurys. Is there a lot of foreign buying that you're seeing? Are there things like the Fed's tapering process that's already begun that are playing into movements or perhaps some of the more kind of plumbing-related things like the standing repo facility being put up by the Fed earlier this year?

TOM GRAFF: Yeah, there's definitely a lot of global interest, particularly when we've seen the 10-year get above 150 and into 160, it's clear that there has been some kind of real asset by insurance companies, foreign pension funds, even sovereign wealth. That sort of buying comes in at those levels, and those buyers tend to be less sensitive to fluctuations, and so they're just willing to own it at a certain yield.

And then also I think there's been a lot of positioning issues. So there have been-- a lot of hedge funds have tried to get short Treasurys over the course of this year at different points and become frustrated and wound up getting stopped out and forced to cover those shorts, and that dynamic has definitely influenced the market. You know, the Treasury market is one of the deepest if not the deepest financial market in the world, but it's not as deep as it used to be, and certain players can get large enough in their shorts that they themselves can influence the market in a way that maybe wasn't true 10 or 20 years ago.

So I think all those dynamics are going on. I think viewers should bear in mind that sometimes those day-by-day changes are influenced by those sorts of things or sort of less economic things and not so much kind of making a big statement about the long-term trajectory of the economy.

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