Markets 'were not expecting the Powell pivot,' strategist says

Angel Oak Capital CIO Sam Dunlap reveals how surprised investors and the markets were at Fed Chair Jerome Powell's hawkishness in his recent inflation testimony to Congress.

Video Transcript

ZACK GUZMAN: And for more on where this market volatility could go, happy to welcome into the program Angel Oak Capital CIO Sam Dunlap here joins us. And, Sam, I mean, you just heard Jared kind of walking us through some of those short-term moves. But when you step back and maybe look at what we learn this week what Jay Powell coming off his transitory inflation stance, and also maybe moving forward the taper rates of dialing back some of those asset purchases.

I mean, it was really a 1-2 punch here for investors. So what do you make of where we're at in this recovery and maybe how tense some of the sell-off concerns are?

SAM DUNLAP: Yeah, great question. The Powell news was certainly something that market participants clearly were not expecting. We were not expecting the Powell pivot that we saw. This is the second Powell pivot.

The first one clearly came where he became much more dovish, clearly, in 2018. And this time around, he's become clearly much more hawkish than market participants were expecting. The big surprise too for us getting ready for his testimony was reading the actual press release prior to him actually going on and testifying to the Senate Banking Committee-- and the tone clearly away from the maximum employment goal changed a lot.

And clearly retiring transitory, and Powell really acknowledging that the inflation pressures are clearly going to be here to stay for some time and is becoming worrisome to them clearly rattled market participants. I think it's worth taking a step back as we think about Fed policy and keeping in mind that the Fed is still extraordinarily accommodative, especially as we head into 2022.

We think the tapering will be definitely manageable next year for a couple of different reasons. So we think that the Fed's potential for lift off into 2022 will easily be digested by the markets, particularly the credit markets where we are focused. And we think now is a real opportunity, as we've seen credit spreads widening here, notably, to your point earlier in your question, about Omicron, which is clearly separate from the Fed is, you know, credit market investors became increasingly concerned about growth, clearly in some of the more COVID sensitive names, et cetera. But we think that this is an opportunity to take advantage of some of this widening that we view as more technical, especially as we head into year-end here.

AKIKO FUJITA: And so what are some of those opportunities you're looking at? And if you look at your portfolio overall, given this Powell pivot, if we want to call it that, what has that meant from your exposure, for example, to growth names?

SAM DUNLAP: So where we focus in US structured credit primarily, and predominantly in mortgage credit, is we still think that income and carry or yield is really critical here, because we're still at the zero bound. And that's very important.

You know, the Fed is going to be quickening the pace of tapering, clearly. But income is really critical. And we're focusing on high current income and relative value in US structured credit with a relatively short duration profile, and really with a mortgage and consumer-centric bias.

So those are non-government guaranteed mortgages with short duration characteristics, less interest rate sensitivity, high current income that are really being bolstered from a credit perspective by a lot of these inflationary consequences that we've seen from this aggressive monetary policy and, clearly, fiscal policy. Surging home values, for example, have really improved the credit profile. And these ultra low mortgage rates have really sped up prepayments, which have kept the duration profile of the securities we target relatively short.

And we would expect a steeper yield curve into 2022 and that positioning to bode well. So we really, again, focus on income. We think it's really critical as you head into 2022. And we've been taking advantage of any widening that we're seeing heading into year-end.

ZACK GUZMAN: You mentioned a steeper yield curve-- it's interesting to watch kind of, I guess, people's forecasts for when those rate hikes can start to come. And maybe, you know-- maybe we've been talking about it even before the Powell pivot-- we're going to stick with that term-- because you kind of started to mention inflation and things like that.

I mean, if you are expecting a pull forward there, we've had a lot of guests highlight financials in terms of sectors to watch as maybe outperformers in one of the leading sectors in 2021-- I mean, would that also be kind of, I guess, the playbook for investors moving into 2022?

SAM DUNLAP: Yeah, we think this flattening is definitely overdone. If you think about the 2s and 10s curve in particular, I think we've had, like, 50 basis points of flattening really after the Omicron and now into this Fed tapering news as market participants are clearly pricing in a quick rise on the front end, and the long end definitely has not risen as fast.

And we would expect as we head into 2022 that market participants will begin to realize that the Fed perhaps, clearly, is going to be focused on the inflation front-- they may not be hiking as fast on the front end in 2022. And we think the curve will begin to steepen as market participants also begin to recognize that we may actually need more tightening way out in the future to address, clearly, more persistent inflation problems ahead.

So we think that the curve will begin its re-steepening path into 2022. And to your point, we think that's good for financials and other areas to benefit from a steeper curve. But we also just think that's good for growth and the general trajectory of the US economy in 2022 as well.