What does the Fed’s pivot tell you?
The Federal Reserve’s (Fed) pivot was Chairman Powell’s big news towards the end of 2021 that they would taper Quantitative Easing (QE) faster in efforts to address rising inflation. This reflects the realization that inflation is not transitory after all, counter to earlier views that inflation was a reflection of Covid-related bottlenecks, which would eventually fade. However, surprisingly strong data, particularly in the labor market, showed some structural inflation. This is not to say that inflation will remain at these very high levels – it could roll over, but the point is that inflation is perhaps running hotter than the Fed would otherwise like. The Fed came out vociferously on their pivot, which was clearly needed.
Any thoughts on where the Fed goes from here regarding QE?
It seems the Fed may just be getting going. There’s something called the shadow policy rate, which is a measurement of the economy when interest rates are at the zero or below range; it allows you to analyze the nominal short-term rate if it were allowed to go below zero. It can indicate how easy monetary policy is in quantitative fashion by actually estimating what the policy effect is in negative yield terms. The shadow rate in nominal terms has been roughly 200 basis points of negative yield, and when you add headline inflation, which has been running around 6%–7%, you’re looking at a roughly negative 8% policy rate. If you were to plot that historically, going back to the 1970s, that’s the lowest it’s ever been. This shows you how accommodative the Fed has been.
In the past, pre-Global Financial Crisis, for example, the initial volley for the Fed in terms of tightening was a rate hike. Today, we’re dealing with QE, where the initial reduction and accommodation comes through QE first. So the question becomes, what is the pace of that, and how quickly will it go?
Your approach at Loomis Sayles focuses on the credit cycle. Where are we currently in the cycle?
We’re still in the expansion phase, though the cycle is advancing more rapidly than we would have otherwise expected due to the Fed starting to move faster. We’re moving towards the late cycle, and how quickly that comes at us will depend on how quickly the Fed moves. We are watching this closely, because even though the Fed has been focused on ensuring that employment markets are healthy and supporting the economy during this pandemic, they can’t let inflation get too far out of hand because that obviously has its own negative consequences down the road.
We still think the Fed will be reasonably slow – even if they’re at what seems aggressive, they’re still going to be accommodative. What can ruin expansions, outside of events like a global pandemic, is usually the Fed that’s holding the gun. We need to make note of this. This is a time for investors to be thoughtful and careful about bond selection.
Does all of this present challenges for investors?
QE lowers real rates, drives them very negative, so that investors can be forced to go out the term structure premium to get yield, moving toward lower quality or risky assets, and also take liquidity risk. All of this can make for an uncomfortable situation for traditional fixed income strategies. Less traditional products with some flexibility to shift can be useful, as managers can build upon yield advantage by dynamically allocating to various risk premiums in the spread sector, towards risk-seeking when returns are skewed in your favor, and pivot back to more principal protection-seeking assets when risk premiums are not in your favor.
Are you seeing opportunities in any areas of the fixed income market?
Domestically, we think there’s yield to be found in securitized debt, primarily in the consumer-related space, including commercial asset-backed securities (ABS), all of which is securitized and up the capitalization structure. We think you get a pretty decent yield per unit of duration, and we like the relatively low duration.
Despite concerns about their zero Covid policy leading to poor domestic consumption, and some self-inflicted pain due to policy changes in areas like property markets, we think opportunities in China could drive performance later this year. Their external economy is very solid, mainly due to US spending and strong consumption. Economically, we might consider them being in the downturn right now with property particularly, but there are opportunities. Just as there would be opportunities during a downturn in US credit markets. This is when active bottom-up security selection can uncover attractive investments.
This material is provided for informational purposes only and should not be construed as investment advice. This material may not be redistributed, published, or reproduced, in whole or in part. The views and opinions expressed are as of January 11, 2022 and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted. Actual results may vary.
Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.
Credit risk is the risk that the issuer of a fixed income security may fail to make timely payments of interest or principal or to otherwise honor its obligations.
Liquidity risk exists when particular investments are difficult to purchase or sell, possibly preventing the sale of these illiquid securities at an advantageous price or time. A lack of liquidity also may cause the value of investments to decline.
Mortgage-related and asset-backed securities are subject to the risks of the mortgages and assets underlying the securities. Other related risks include prepayment risk, which is the risk that the securities may be prepaid, potentially resulting in the reinvestment of the prepaid amounts into securities with lower yields.
Asset-backed securities (ABS) are pools of loans that are packaged and sold to investors as securities.
Quantitative Easing (QE) refers to monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
The real interest rate is the rate of interest an investor, saver or lender receives after allowing for inflation.
The risk premium is the rate of return on an investment over and above the risk-free or guaranteed rate of return.
Duration is a bond’s price sensitivity to interest rate changes.
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