The FED doesn't blink Kapstream Capital March 2023 Kapstream's Portfolio Manager, Dan Siluk, explains why the Federal Reserve (Fed) opted to raise rates and highlights the threat posed by persistently high inflation despite recent upheaval in the banking sector. Key takeaways: While acknowledging the recent developments in the banking sector, Fed Chairman Jerome Powell emphasized that the central bank's primary focus continues to be guiding inflation toward its 2.0% target. Although relatively hawkish, the Fed's move was likely tempered by tightening credit conditions weighing on consumers' and businesses' ability to borrow, which could act as an economic headwind. A bullish pivot likely doesn't await investors, but by delivering a 25 basis point (bps) rate hike, the Fed may have decreased the chance of a policy error that could send bond yields markedly higher. After nearly two weeks of speculation, with a few pointed sentences Federal Reserve (Fed) Chairman Jerome Powell reaffirmed that the Federal Open Market Committee's (FOMC) highest priority remains price stability, while also acknowledging that recent banking sector upheaval and its impact on credit availability are developments they cannot dismiss. By shifting the focus back to inflation and a tight labour market despite indications of a slowing economy, Chairman Powell provided the context for the FOMC's 25 bps rate hike to a range of 4.75% to 5.00%. Even with the focus squarely on inflation, we believe the impact of the banking turmoil was already evident in Chairman Powell's statement. In his Congressional testimony only a few weeks ago, he hinted that rates would likely have to rise higher than the market anticipated. Taking him at his word, futures prices responded by implying the terminal rate would climb as high as 5.75% in mid-2023. Fast forward to Wednesday and his message morphed to a less certain "some additional policy firming may be appropriate." All eyes on the mandate Citing "robust" job gains keeping stickier drivers of inflation - e.g., wages - elevated, Chairman Powell emphasized that there is much work to be done in achieving the Fed's objective of 2.0% inflation. This meeting's update to the Summary of Economic Projections reflected the Fed's modestly hawkish thinking. Estimates for 2023 headline and core inflation were revised upward to 3.3% and 3.6%, respectively. The challenge facing the Fed is acutely illustrated in the incongruity of paltry 2023 gross domestic product growth of 0.4% and the year's unemployment rate being revised down to 4.5%. While banking sector turbulence has sent 2-year Treasury yields lower, sticky inflation could reverse that trend   Source: Bloomberg, as of 22 March 2023. Given the recent developments in the banking sector, we had suspected that the Fed could have considered a 2023 pivot as lenders' health can materially impact financial conditions. Chairman Powell, however, dismissed that scenario, noting that the FOMC does not see a rate cut occurring this year. In fact, the Fed's much ballyhooed DOTS survey revealed that respondents see the fed funds rate finishing 2024 at 4.3% - slightly higher than the 4.1% suggested in its December survey. We interpret this as the Fed being willing to leave rates at their cycle high for longer than what the market is currently pricing in. Such a pause would give the central bank time to assess the impact of previous rate hikes and other tightening initiatives. We believe the Fed was correct in shifting the conversation back toward its battle with inflation. Even before most people had ever heard of Silicon Valley Bank (SVB), the Fed was faced with striking a delicate balance between reducing inflation and inflicting as little harm as possible on the economy. That battle has not gone away. Breaking something Arguably, the genesis of the current banking turmoil was last year's rise in interest rates, which led to the mismatch between SVB's assets and liabilities and resulted in the run on the bank. We often state that the purpose of monetary tightening is to break something. Typically, what gets broken first are the weaker business models and pockets of the economy that are dependent upon low rates. While regional banks with narrow customer bases may be the first segment to give way, they may not be the last, and investors must be wary of what else higher rates could expose. In his statement, Chairman Powell emphasized that the U.S. banking sector was "sound and resilient." This is due, in part, to the action taken by the Fed in concert with the U.S. Treasury to shore up banks' access to funding. Thanks to the alphabet soup of policy prescriptions created during the Global Financial Crisis, the Fed has a full cupboard of facilities well-suited to addressing financial stability. This leaves the fed funds rate available for the task at which it's effective: addressing inflation. Bringing this full circle, the stress to regional banks that initially caused a historic rise in rates may, in the end, assist the Fed in tightening financial conditions. Mr. Powell made a point to highlight that households and businesses are likely to face tighter credit conditions. This is in addition to higher rates already negatively impacting the housing market and business investment. Narrowing rates' range of outcomes? We think recent developments - and the Fed's decision - leaves much for investors to digest. In one respect, the added headwind of tightening credit conditions means that the near-term ceiling for interest rates may be lower than it was in early March. This could lead to lower volatility in shorter-dated bonds. Still, we see a disconnect between the yield on the 2-year U.S. Treasury of roughly 4.0% and the end-of-2023 DOTS projection of 5.1% for the fed funds rate. This disparity may reflect the Fed's concern that it's too soon to declare victory in its battle against inflation. In contrast to the Fed's expectations for its benchmark rate, the futures market believes a dovish pivot is in the cards by the end of 2023   Source: Bloomberg, as of 22 March 2023. Recent market and economic developments have no doubt tested the Fed. We appreciate that its focus remains on price stability, as imbedded inflation expectations can lead to long-lasting price distortions across the economy. By recognizing that it has the facilities at its disposal to address financial stability, the Fed can keep another 25 bps rate hike on the table should consumer prices remain uncomfortably hot and the labour market tight. In choosing a circumspect hike rather than the pause many had called for, the Powell Fed, in our view, has passed the initial test of not blinking at the first sign of something breaking, which - as history has shown - only results in more difficult battles down the road in containing inflation and longer-term rates.  Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%. The Federal Open Market Committee (FOMC) is the body of the Federal Reserve System that sets national monetary policy. The FOMC dot plot is a chart that summarizes the FOMC's outlook for the federal funds rate. Disclosure: This information is for adviser & wholesale investors only Funds operated by this manager: Kapstream Absolute Return Income Fund This material has been prepared by Kapstream Capital Pty Limited (ABN 19 122 076 117 AFSL 308870) (Kapstream), the investment manager of the Kapstream Absolute Return Income Fund & Kapstream Absolute Return Income Plus Fund ('Funds'). Fidante Partners Limited ABN 94 002 835 592 AFSL 234668 (Fidante) is a member of the Challenger Limited group of companies (Challenger Group) and is the responsible entity of the Funds. Other than information which is identified as sourced from Fidante in relation to the Funds, Fidante is not responsible for the information in this material, including any statements of opinion. It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. 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On the future path of rates: Pause does not equal pivot Kapstream Capital November 2022 Impact of higher global bond yields The Federal Reserve (Fed) acknowledged that "cumulative tightening" will be a factor in future rate decisions, but we still believe the central bank will be forced to remain hawkish longer than it expects. While we believe a pause in rate hikes by mid-2023 is possible, we expect it would be an effort to measure the lagging effects of earlier hikes rather than the first step toward a dovish pivot. Although the resetting of monetary policy has been painful, over the longer term, the return of positive real yields and the potential diversification benefits to riskier assets should prove beneficial to bond investors. The Federal Reserve's (Fed) Wednesday decision to increase the upper limit of its benchmark overnight lending rate by 75 basis points (bps) to 4.00% was easy for the market to anticipate, given the degree to which U.S. central bank officials have telegraphed their priority of getting generationally high inflation under control. Where we think the market may be misreading the Fed, however, is the monetary authority's willingness - or ability - to take its foot off the gas. Using futures prices as a yardstick, expectations are coalescing around the view that the Fed's policy path may peak by as early as next May and that a rate cut could be possible soon thereafter. In fact, after today's statement, the futures-implied rate path through mid-2023 dipped, due in part to the insertion of language that "cumulative tightening" would be factor in future moves. We consider it wishful thinking on the part of shell-shocked investors that all of the pain associated with the resetting of rates to more "normal" levels is behind us. Expected trajectory of Fed funds rate based on futures market prices We don't agree with the futures market's view that a mid-2023 pause in rate hikes will inevitably lead to a dovish pivot. Source: Bloomberg as of 2 November 2022. Note: For normalization purposes, estimates based on 2 November include the 75 bps hike that occurred at the November meeting. We think only a material deterioration of economic conditions, likely brought on by an exogenous event, would cause the Fed to abandon its hawkish resolve. This is not our base-case, however. We, too, expect the path of policy rates to pause within the next several months but, importantly, pause does not mean pivot. As rates rise at a pace not seen in a decades, we've been consistently reminded of the long and variable lags of such actions. It's our view that a mid-2023 pause would serve the purpose of allowing the Fed to measure the effects of previous "cumulative tightening rather than sending an "all clear" signal. More work to be done Driving our view that a pivot is unlikely is the magnitude of the task at hand. Given the added nuance of today's statement, we may even be more circumspect than the Fed. Despite the equivalent of 15 25 bps rate hikes this cycle, the inflation-adjusted - or real - overnight policy rate1 remains below -4.0%. If the goal is to push borrowing costs into positive territory - i.e., no more free money in real terms - there is much work to be done. Other measures also hint at the need for the Fed to remain vigilant. In a service-based economy such as the U.S., wages play a pivotal role in driving inflation. Fed officials have long sought to stave off a self-fulling wage-price spiral. The annual change in real average hourly earnings is -3.2%. At that dismal level, workers are likely to capitalize on a still tight labour market to press for higher pay to maintain purchasing power. And while shelter's sizable contribution to inflation may start to wane once lease renewals fully incorporate this year's uptick in prices and higher mortgage rates cool the housing market, energy prices again appear to be on the march as global crude production is curtailed. Inflation-adjusted Fed funds rate If the goal is to tap the breaks on the economy by sending short-term borrowing costs into positive territory, policy rates will likely have to keep climbing. Source: Bloomberg as of 2 November 2022. Grasping at straws We think much of this meeting's sentiment aligns more with our cautious view than it does with the broader market's more optimistic interpretation. Since their most-recent bottom in mid-October, U.S. equities have rallied over 9.0%. In recent sessions, the bond market as measured by the Bloomberg U.S. Aggregate Index has notched modest gains as well. While that was largely driven by the longer-dated tenors that could rally as an economic slowdown is priced in, upward pressure on shorter-dated yields has also eased. Our concern is that investors may be underestimating either the difficulty of achieving price stability or the Fed's commitment to it. This is not to say that the U.S. - and global - economy will prove impervious to tightening. The economic outlook has indeed become more challenged. Driving our view is synchronized - albeit not coordinated - tightening across nearly all major economies. In regions where the post-pandemic recovery never fully blossomed, policymakers face the daunting scenario of stagflation. As evidenced by the bond market's reaction to the previous - and incredibly short-lived - UK government's fiscal fiasco2, countries that run persistent deficits are at acute risk as the cost of financing these imbalances increases. The end of an era Rising real interest rates likely harken the closing chapter of the decade-long run of financial repression where borrowers could feast on cheap and readily available debt financing. Looking forward, we believe both corporations and governments will be scrutinized more closely with respect to their ability to sufficiently cover their debt obligations. While the path to this destination is proving rocky, we think the end result will likely be a more efficient capital transmission mechanism where investors will be fairly compensated for the risks they choose to bear when participating in financial markets. When the economic history books on the early part of the 21st century are written, an undeniable conclusion, in our view, will be that over a decade's worth of quantitative easing failed to stimulate inflation and robust economic growth. Rather, it was the fiscal blowout accompanying the pandemic that finally caused prices to accelerate. But policy makers are now facing the unintended consequences of their largesse. This is especially true in regions that must continue to hike rates even as stagflation risks rise, and in the U.S., where the Fed's laser-focus on backward-looking labour market data is likely to result in recession at some point in the near future. Still, this year's resetting of interest rates at considerably higher levels has given bond investors the opportunity to again benefit from the characteristics that have historically been the hallmark of a fixed income allocation: steady income, diversification from riskier asset classes, and - depending on how effectively the market has priced in future upward moves in interest rates - capital preservation. We believe the first two tenets have arrived but are more circumspect on the latter, as we believe that central banks have more work to do in taming inflation. We expect slowing growth and cooling inflation to be uneven, and this should create opportunities to increase allocations to geographies where policymakers are able to hit pause on monetary tightening. Disclosure: This information is for adviser & wholesale investors only Funds operated by this manager: Kapstream Absolute Return Income Fund

Another step toward policy tightening - with a caveat Kapstream Capital March 2022 Key Takeaways As expected, accelerating inflation forced the hand of the Federal Reserve (Fed) to initiate its first 25 basis point (bps) rate increase of this cycle, thus ending the pandemic-era zero-percent interest rate policy. In our view, high inflation has placed the Fed on a narrow path and increased the risk of policy error, with two potential outcomes - slowing growth and embedded higher inflation expectations - vying for supremacy. With our expectation that U.S. monetary policy will ultimately prove to be more dovish than many expect, we believe longer-dated bonds remain at risk to continuing inflationary pressure. In a well-telegraphed move, the Federal Reserve (Fed) raised its benchmark overnight policy rate by 25 basis points (bps) on Wednesday (March 16) to a range of 0.25% to 0.50%. Perhaps more importantly, the U.S. central bank's own forecast for the future path of rate hikes - as expressed in its "Dots" survey, which records each Fed official's projection for the federal funds rate - increased to seven hikes for this year and four for 2023. In the December survey, these expectations were for three hikes in each of these years. While some may interpret this as a continuation in the shift toward a hawkish bias, we are more circumspect. We believe that the seven 25 bps rate increases the futures market is pricing in for this year very much represent an upper limit of potential hikes and that this scenario is unlikely to materialize. Also, the current Dots survey comes with a considerable caveat: There were fewer voting members at this week's meeting due to the ongoing transition in the Fed's leadership composition and none of President Biden's nominees have taken their seat. Importantly, we believe that eventual new members will lean toward the dovish camp, reinforcing our view that the market's expectations have gotten ahead of reality. It's worth recalling that throughout Chairman Jerome Powell's tenure, when given the choice between two paths - and having not been mugged by multi-decade highs in inflation - he's opted for greater accommodation. About that Inflation The reality that Chairman Powell has been unable to avoid is that inflation remains on the march. In February, both the headline and core U.S. consumer price indexes reached multi-decade highs - 7.9% and 6.4%, respectively. Market expectations for price increases to drift toward the Fed's preferred 2.0% long-term range look slim. Inflation is expected to average 3.6% over the next five years based on the U.S. Treasury Inflation-Protected Securities (TIPS) market. For the 10-year horizon, the average is a modestly less ulcer-inducing 2.95%. We interpret these elevated levels as the market's growing recognition that the Fed will be more tolerant of a pace of inflation seldom seen in the U.S. over the past three decades. Yet the Fed faces a conundrum. Much of the current upward lurch in prices is due to supply constraints. The global pandemic famously caused supply disruptions in semiconductors and other important industrial inputs. Labor shortages have led to upward pressure on wages, which feed directly into inflation, especially in service-based economies. Unfortunately for the Fed, the blunt instrument of rate hikes tends to be less effective in combating inflation driven by supply factors than it is in quelling periods of accelerating prices driven by full-throttle demand. A Narrowing Policy Path The nature of this bout of inflation, which has been exacerbated by recent geopolitical events, amplifies our concerns about the potential for monetary policy error. Policymakers must perform a perilous balancing act. Should the Fed overtighten, the U.S. economy could slip into recession. If it falls behind the curve and higher inflation expectations become embedded, bond valuations could come under pressure as higher discounts are commanded to compensate for the diminished value of future cash flows. Caution Merited The expected template of a methodical pace of rate increases in 2022 has been turned upside down. We believe that every Fed meeting has the potential to be "live," meaning that a rate hike is possible. While it would likely be well-telegraphed per Chairman Powell's modus operandi, we cannot rule out a 50 bps hike at some point. The forced shift in the Fed's stance, however, means that the period of "peak policy uncertainty" has likely been extended. Our view is that the Fed will make every attempt to proceed with caution. Yet, this same caution could lead to even more volatility in longer-dated rates as the risk of higher-than-trend inflation becomes fixed in investors' minds. Consequently, we believe investors should treat interest rate exposure - or duration - with caution. Longer-dated bonds, in our view, appear most vulnerable to elevated volatility. And given the relative flatness of the yield curve, the incremental return for holding farther out maturities may not be worth the higher risk. Lastly, the geopolitical uncertainty emanating from events in Ukraine further reinforces our view that now is not the time to take on any undue risk in one's fixed income allocation. Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%. Duration measures a bond price's sensitivity to changes in interest rates. The longer a bond's duration, the higher its sensitivity to changes in interest rates and vice versa.   This information is for adviser & wholesale investors only Funds operated by this manager: Kapstream Absolute Return Income Fund