The Fed’s hawkish stance ‘the start of something bigger'

Morgan Stanley Investment Management Fixed Income Portfolio, Jim Caron, joins Yahoo Finance to discuss what to expect in the market as the Fed continues to decide on the policy they need to enact in order to fight inflation concerns.

Video Transcript

MYLES UDLAND: Let's talk a little bit more about the state of the economy though, and how the Fed is thinking about where to go from here. Jim Caron joins us now. He is a Fixed Income Portfolio Manager at Morgan Stanley Investment Management. Jim, thanks for jumping on this morning.

So, you know, you have an interesting comment in your note that I think is maybe going under discussed among the Fed conversation, which is clearly pro-cyclical policy, both from fiscal policy makers and the Fed during the crisis. You know, we're going to do everything we can to support the recovery, and you know, it does seem like we are very quickly going back to maybe let's not call it austerity, but a 2010s era kind of caution around just how aggressive policymakers want to be.

JIM CARON: Yeah, thanks-- well, first of all, thank you for having me on your show again. It does seem pretty interesting right now because there seems to be a wide range of opinions at the Fed at this point. So, we've seen different speakers, Bostic, we've seen Bullard. They're definitely much more on the hawkish end. We've seen Clarida, we've seen Williams, and also Chair Powell, that seem to be much more on the dovish end.

So, it's hard to know if we're going back into an austerity period as much as what we're trying to do is really just to market the recent rise in inflation, which has been pretty substantial and robust. But what we also have to remember is that this is very, very data dependent. And I think that we've seen the peak in inflation. And now, going forward in the next several months and quarters, you're going to see lower and lower inflation.

And it's going to be easier for the doves, I think, to win the narrative on this. But right now, the narrative, and it is a narrative, is so far probably tilted towards the hawks, just given the most recent data points that have showed such high inflation.

BRIAN SOZZI: Jim, how confident are you that the Fed won't put the US economy into a recession as it tapers its bond purchases and as it hikes rates?

JIM CARON: Yeah, I'm pretty confident of that because they can control it, right? So, they can control the tapering. They can control the pace of their rate hikes.

The last thing that they want to do is cut this economic cycle short. I think they want to make sure that inflation remains anchored. And I think that's some of the more hawkish rhetoric that's coming out of the Fed right now, is that they want to ensure that inflation remains anchored, they don't want to see this run away. And there's a couple of reasons for this. Number one is that if inflation does start to move higher, then that's going to hurt the lower demographic wage earners and income earners the most.

And also, it means that if inflation runs out of control higher, then that means they have to tighten more aggressively, which means that you have a sharper downturn. So, I think they want to avoid this at all costs. And that's one of the things I mentioned is that they're still an pro-cyclical policy, meaning that their policy is still to support good economic growth and reasonable levels of inflation, as long as they remain anchored, and we think that's between 2 and 2 and 1/2 percent.

JULIE HYMAN: And Jim, what's interesting is, you hear a lot of rhetoric out there about this alarm that the Fed is going to make a mistake about the idea that inflation might not be transitory. At this point, is that being exhibited really in the market anywhere on the fixed income side?

JIM CARON: So, Julie, I think this is a great question because it's exactly where I wanted to go with this discussion. When we think about what has actually changed, right. So, 10-year break evens, for example, are back to about the same levels that they were prior to the Fed's announcement the day before the announcement. If we look at 10-year real yields, which is a measure-- I use this as a measure of economic monetary stimulus in the markets, is about at the exact same levels as we were just prior to the Fed.

When we look at high yields right now, high yield is trading at a 280 basis point spread and 3.9% is trading under 4%. It's five basis points off of its all-time lows in yields. Investment grade spreads, 82 basis points. These are the lows of the year.

Equity markets still continue to be doing very, very well at this point in time. So, what's off right now? It's the dollar, right? So, the dollar has gained some strength, and I think that has a lot more to do with positioning. Also, the yield curve. The yield curve has flattened.

The front end rates have risen. That's been the big repricing. That's been the majority repricing in the marketplace, and that's what still has moved with the Fed. But everything else is pretty much unchanged since the day we-- since the day prior of the Fed's announcement.

MYLES UDLAND: All right, now we're seeing the opening bell on this Thursday morning. Doximity ringing the opening bell there. We're going to be talking to the company's CEO at the 12:00 PM hour here on Yahoo Finance.

Jim, I'm just curious, and I always love to ask folks this question. What are investors asking you guys right now? Because I think you did a great job of outlining what has happened in markets. But sometimes, you get the sense that we are benchmarked to what had happened or what people think is going to happen, particularly as it relates to yields and inflation. And I think you outlined there how markets are viewing this maybe differently in the popular conversation today.

JIM CARON: Yeah, that's a fair point. Investors are a little bit nervous. Investors-- what investors are saying is that, is this the start of something bigger? Whenever the Fed starts to move their dots in the dot plot and starts to become hawkish, it's usually not a one off event. Usually it's the start of more hawkish rhetoric, and then eventually the Fed follows through, and then they surprise with more tightening.

That's the pattern that we've seen for the last several decades with the Fed, and that's really the Fed being in a countercyclical type of a mode, meaning that they counter the economic cycle so that it doesn't get too hot or doesn't get too cold. So, they tend to hike rates a lot when the economy's over prior to the economy overheating so they stay ahead of the curve.

But I do think, though, that it is difficult to make this-- to make this case, it's nuance, but the Fed does want to stay behind the curve. So, they still want the economy to run hot. That's the conversation that we're having with a lot of our investors, because most people see this as, wait, the Fed has just become hawkish. What I've learned over the past 40 years is when that happens, markets tend to do poorly not too long thereafter.

And what we're saying is that, it might be a little bit different this time, given that the Fed wants to extend the length of the economic cycle as much as possible, and that we still may be in more of a mid cycle as opposed to a late cycle phase. But this is all nuance, and people are starting to get nervous, you know, with the recent commentary from the Fed. That-- that I will admit.

MYLES UDLAND: And so then, just finally, how are you guys positioned into this kind of environment? Have you made any big changes or are you still convicted with how you were setting things up into '21?

JIM CARON: Yeah, we still have high conviction in it. We still think this is a reflationary environment, it's a pro-cyclical Fed. You know, as I mentioned earlier, spreads are still tight, they're going tighter. They're already getting near historically tight levels. So, we know the valuations are full, but so far, our interest rate volatility has been relatively low. Equity markets, other risky markets, aren't really sending any major signals.

Yes, the dollar has strengthened, and our view is to be underweight the dollar. But it's only marginal at this point. And still, the dollar has lost ground, and it's still, I think, the dollar is in a structural bear market, and this is a minor correction. So, we really haven't changed.

And really what we're looking for is some dislocations where there might be some opportunities to get back involved as people clean up some positions. And I think much of the move in the market really has been about positioning, at least in fixed income.

MYLES UDLAND: All right, there you go. Flows tell you the story. Jim Caron, Portfolio Manager Chief Strategist at Morgan Stanley Investment Management. Jim, appreciate the time, as always. I know we'll talk soon.