When Bob Michele shares his investment views, it’s worth paying attention because the bond market veteran has proved to be pretty prescient.
(Bloomberg) — When Bob Michele shares his investment views, it’s worth paying attention because the bond market veteran has proved to be pretty prescient.
The chief investment officer at J.P. Morgan Asset Management is warning that the Federal Reserve could continue the fight against inflation in the second half, pushing terminal rates to as high as 6%. That defies a growing consensus that interest rates will peak in June.
“It’s still a one-in-three chance, but it’s a legitimate risk,” Michele said in an interview. “It is possible the Fed will not initially do enough because the labor market proved more resilient. This is one thing that can unravel the market, and it’s my biggest concern.”
Inflation is easing, although it’s still well above the Fed target of 2%. Consumer prices rose 6.5% in December, the slowest pace in more than a year, showing that aggressive Fed policy tightening is working. The results met expectations and the market now expects rates to top out at 4.9% in June and potential rate cuts to follow, according to Bloomberg data.
Michele’s base case is that the Fed will raise interest rates in February and March before pausing, and a recession will set in later this year. But he also sees the possibility of policymakers returning to rate hikes in late 2023 to cool down stubbornly high inflation fueled by low unemployment, persistent wage gain and China’s economic reopening.
“The equation is: inflation doesn’t come down until wages do. Wages don’t come down until unemployment rises,” he said. “Unemployment doesn’t rise unless we are in recession.”
The latest jobs data shows decelerating wage growth, but robust hiring and unemployment still at a historic low.
Since 1988, the Fed has gone through five rate-hiking cycles, which ended in recession four times, according to Michele. The only one that did not result in economic contraction was the 1994-1995 cycle which ended in a soft landing. But he said 2023 isn’t going to be another 1994.
“The delayed and cumulative impact of all the tightening that we are seeing ultimately will bite and create a recession,” said Michele. “It’s incredibly aspirational to think we are going to get away with that.”
In December, Michele bought “quality duration” assets like government bonds, investment-grade credit as well as mortgage-backed securities and asset-backed securities.
He also favors emerging-market local currency bonds, which he said could easily generate double-digit returns this year as the dollar peaks. Central banks in those markets have been far ahead of their developed-economy peers like the US in raising rates.
Michele warned that the yields for Japan’s 10-year government bonds could rise to 1% from 0.5% and the dollar-yen will fall to 100 as the Bank of Japan ends its yield curve control. Market participants wagering on another tweak pushed the benchmark 10-year yield past the central bank’s 0.5% ceiling on Friday. This will turn Japan from “mother of all carry trades” into “mother of all repatriation,” he said.
“We are not going to hedge against the risk that the Fed may have to return to rate hikes later in the year. But, we are going to be open-minded and accept that there is a reasonable probability that it could happen and be prepared,” said Michele, who recommends selling short-dated bonds and lower-rated corporate bonds in the event of rising rates.
It probably pays to heed Michele’s admonitions. In 2019, Michele famously rode the bull run in US bonds, predicting that yields were “headed to zero” when the 10-year benchmark was trading at 2%. He reaped the rewards as the yield fell all the way to 0.5% within a year.
Read more: Bob Michele Warns the 10-Year Treasury Yield Is ‘Headed to Zero’
Back in October 2021, when most economists polled by Bloomberg expected the Fed to hold rates near zero through the end of 2022, Michele said the central bank was way behind the curve and would need to aggressively fight inflation, bringing rates to at least 4.25%. The Fed raised its benchmark rate to a range of 4.25% to 4.5% at the end of 2022.
He was also among the first investors who highlighted the risk of the European Central Bank raising official borrowing costs last year to cool inflation — a concept that was deemed highly unlikely for a lot of market watchers at that time. The ECB raised its deposit rates four times last year, bringing it to 2%.
“One of the reasons we put together these realistic risks is so that we can keep an eye on them, so that we are not caught off guard,” Michele said. “Last year, they all played out. Because we thought of these risks, we don’t get blindsided.”
–With assistance from Liz Capo McCormick and Michael MacKenzie.
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