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Even though the Fed will hike interest rates, doesn’t mean they’re tightening: Portfolio Manager

Jim Caron, Morgan Stanley Investment Management Fixed Income Portfolio Manager, joins Yahoo Finance to discuss the China credit risk, inflation, the U.S. economy, and outlook on the Fed.

Video transcript

AKIKO FUJITA: Let's turn to our first guest for the hour. We've got Jim Caron, Morgan Stanley Investment Management Fixed Income Portfolio Manager. And Jim, we started out the week with a huge sell off stemming from concerns around property giant Evergrande. We don't have any more clarity on whether, in fact, they're going to make that $83 million interest payment. But how are you assessing the China credit risk overall in light of the latest headlines?

JIM CARON: Well, first of all, Akiko, thank you for having me on your show. The way that we assess this risk is like we assess any other global potential risk, is by trying to find and track the fault lines. And typically, what we will see, if something is going to become a systemic event, we will see a lot of funding-- sorry, we will see a lot of pressure on the dollar funding markets.

So in one sense, you would see a sharp spike higher in the dollar. You could see repo rates move higher, things like the cross-currency basis, a lot of these technical factors that really represent leverage in funding and liquidity. And right now, we're not seeing any of these fault lines really show up as something that is indicating to us that this is going to be a systemic event.

Look, in credit markets, defaults happen. Some defaults are bigger than others, and I recognize that there is risk around this, where it could become a bigger problem, but all we're going to do is assess what we know at the moment. And at the moment, what we're seeing is no real signs of stress in terms of contagion and this spilling over into other markets.

AKIKO FUJITA: Jim, this has raised larger questions about where the overall macro outlook for China, where that's headed, whether, in fact, Xi Jinping is sort of willing to rein in some of these companies that are very debt ridden, if you will, and look more for quality growth instead of the type-- the pace of growth that China has seen over the last decade or so.

I know it's a discussion that's been happening around China for many, many years, but does your assessment around the growth potential in China, has that changed as a result of the latest headlines that have come out not just in the property space, but other spaces as well? And what does that mean in terms of the ripple effects that could have outside of China?

JIM CARON: So Akiko, I-- yeah. So Akiko, I think that's a great question because, if there is going to be some type of global event that takes place, we have to remember that China is the second largest economy in the world. And if what we're seeing happening there is going to lead to slower growth, that's going to weigh on global growth. And if global growth slows down, that can weigh on financial markets just broadly all around the world.

So if we start to think about this as a part of a process, what we as investors start to think is who's next, and when does it end? And if we're constantly questioning ourselves as to who's next, when does it end, could there be another accident looming in the future, something that might be bigger or something that could even be contained, either way it's disruptive.

And what it does is it increases the risk premium for holding financial assets, especially credit assets, because what we have to remember is that this can spill over into high-yield markets, into investment-grade markets, and what have you. And it's hard to differentiate how much China exposure you actually have. Again, it's the second largest economy in the world. It's got parts. It's a factor for all of us in terms of how we value things. So this is a key question that it may result in slower growth in China, which would weigh on slower growth for the rest of the world.

AKIKO FUJITA: On the domestic front, we had the Bipartisan Policy Center today coming out saying the US government could run out of money by October 15 at the earliest. We're, of course, talking about missed payments on things like Social Security as a result. How big of an economic shock do you think it will be if, in fact, Democrats and Republicans aren't able to reach some kind of resolution to avert a government shutdown?

JIM CARON: Yeah, this is something that comes up whenever the debt ceiling is around, and it gets hotly debated. And there are times when the government does have to pare back on its spending, but that spending is made up for. So in other words, if there's a missed payment in Social Security, you'll just get it a little bit later. But clearly, that doesn't help people who are living paycheck to paycheck and really depend on that.

Look, what we think is that this ultimately gets resolved, as it typically does. It's just a question of the pathway to how it gets resolved. How disruptive is it? How much does it-- how much does the market start to lose confidence and start to-- and how much does volatility creep into asset prices as a result of this?

So unfortunately, I hate to say this, but it's almost like things have to get worse before they get better before there's real motivation amongst the politicians to say, hey, this isn't going to benefit any of us. This is-- this should not be a partisan discussion, right?

This hurts everybody. This benefits everybody. So this should be something that's much, much more bipartisan. And unfortunately, things are very partisan right now. And until, I think, the pain gets amped up a little bit more, I don't think we see a resolution.

So I would see this going into the mid-October, even late October period. So we may even push it right to the brink. Markets never like that.

AKIKO FUJITA: And finally, Jim, I'm watching the 10-year T-note very closely here. We've seen it tick higher. It was around, what, 1.33 pre-Fed statement that came out. It's at 1.45 now. The FOMC obviously indicating it could begin tapering its asset purchases as soon as the next meeting.

What are the bond markets telling you right now about the expectation of how quickly this could happen? And on a personal note here, I wonder what your takeaway was from the comments that we got. Is there a sense here that the Fed chair maybe is a little more concerned about those inflation risks rising than we had previously heard?

JIM CARON: It's pretty interesting here, right? Because we have many of the forecasters on the FOMC projecting that rate hikes could start as early as late 2022. I think tapering will begin probably sometime in December. It may get announced in November and start in December, but what's also very interesting is some of the things that Powell said during the press conference. Because what's interesting is if you look at the dot plot, the forecasters actually suggested a much hawkish statement.

When you look at what Powell said during the press conference, he walked a lot of that back. And one of the key points-- and I think this is important to highlight-- is that what he said is that even though many forecasters have upped their rate forecasts, their policy rate forecast, still, even the most hawkish amongst them still have their policy rate forecasts below the neutral rate, meaning that if the neutral real Fed funds rate is supposed to be zero-- so that's the policy rate minus inflation.

If inflation is expected to stay stickier for a little bit longer, between the 2% and 2.5% area, and as we saw the median forecast go out to 1.75% by 2024, that would mean that the policy rate would still be lower than the inflation rate. So when you subtract the two, you still get a policy rate of, like, minus 25 to minus 50 basis points, which is still very accommodative.

So what the market is interpreting this as is that still the Fed, even though they will hike interest rates, that doesn't mean they're tightening because they're not hiking interest rates such that the real policy rate goes to the-- goes into positive territory. And then that really shows a tightening or an increase in credit costs.

So I think that's what the market's seeing. And therefore, it's building in inflation risk term premia. The back end of the curve, the 10-year note, like you pointed out, 1.45%; the 30-year bond pushing out to 2%, very close to it-- all of these things are really just the outcome of what I think is a Fed policy that's going to run hotter for longer and more accepting of higher inflation.

AKIKO FUJITA: Jim, it's always good to get your analysis. Appreciate you joining us today. Jim Caron, Morgan Stanley Investment Management Fixed Income Portfolio Manager.