Policy divergence revisited

Three years ago, the Fed had begun tightening and all other central banks were still on easy street. Now, we are at an inflection point where the Fed is now the outlier. Other central banks are likely to tighten more than the Fed. That’s negative for the US dollar and positive for longer duration US Treasuries.

Policy divergence was the watchword in late 2014. As Europe struggled to extract itself from the ravages of the sovereign debt crisis, the Fed was already tightening by freezing its balance sheet. By December 2015, it began to hike rates. But recently, there has been a shift in Fed policy – I think toward dovishness. St. Louis Fed President Jim Bullard has been way ahead of the curve here because he foreshadowed the shift in February. Take a look at how the news release at the St. Louis Fed expressed his views at the time:

“Now that the policy rate has been increased, the FOMC may be in a better position to allow reinvestment to end or to otherwise reduce the size of the balance sheet,” he said.

In addition, Bullard noted that current FOMC policy is distorting the yield curve. “The current FOMC policy is putting some upward pressure on the short end of the yield curve through actual and projected movements in the policy rate,” he said, adding, “at the same time, current policy is putting downward pressure on other portions of the yield curve by maintaining a $4.45 trillion balance sheet.”

He noted that this type of “twist operation” does not appear to have a theoretical basis and that a more natural normalization process would allow the entire yield curve to adjust appropriately as normalization proceeds.

He concluded, “Ending balance sheet reinvestment may allow for a more natural adjustment of rates across the yield curve as normalization proceeds.”

What Bullard was saying in February was that if the Fed raised rates too quickly, it would flatten the yield curve and could choke off recovery. He said in February “adjustments to balance sheet policy might be viewed as a way to normalize Fed policy without relying exclusively on a higher policy rate path.” And this is, in fact, now officially Fed policy.

Now let’s remember that when the Fed first switched to talking about tightening using the balance sheet it made it seem like it could do both balance sheet reduction and rate hikes simultaneously – what I called ‘double-barrelled tightening’. This would be the tightening equivalent of cutting rates and doing QE at the same time – something the Fed never actually did by the way, since it cut to zero first and then added QE later. Right from the start, I told you that wasn’t going to happen because it would be a policy error.

My view has been that the Fed would move into Bullard territory and switch to the balance sheet approach, delaying rate hikes. Bullard was saying all along that we were stuck in a “low-safe-real-rate regime” which basically means that he refuses to predict higher rates at any time into future as appropriate until some point when the real-rate regime changes. Translation: there will be no double-barrelled tightening. The balance sheet will come into play rather than rates.

The evidence that this turn is happening is mounting.

Fed Governor Lael Brainard is a good bellwether here since she foreshadowed the last Fed pause in 2016. In a speech earlier this week, she said, “it could take a considerable undershooting of the natural rate of unemployment to achieve our inflation objective.” That’s Fedspeak for “we don’t have to raise rates as aggressively as we’ve been saying we would. Why? Because I think there’s evidence we can let the unemployment rate go really, really low before we have to raise rates due to any worries about inflation.” 

Now let’s remember that the Fed hasn’t met its inflation target for five years. There was the hit to energy prices in the summer that would keep inflation down. There was also the chatter about Amazon’s acquisition of Whole Foods driving down food prices. Inflation is now moving down, away from the 2% target.

And on top of this, Fed researchers have recently told us that there may be no effective way to predict any trade-off between unemployment and inflation. Rate hikes because of low unemployment – even in the face of persistently low inflation – what I call Fed-engineered unemployment – are getting assaulted from all sides. And long-dated Treasuries are benefitting. From an investing perspective, there are two key takeaways.

One, duration is king in the Bullard “low-safe-real-rate regime”. As long as yields remain low, many investors will have to lengthen duration to get yield. The US 10-year is trading at 2.04%, down 23 basis points in the last month. That’s not only a signal of lower expectations about future rate hikes, it is also a reflection of a preference for long-dated safe assets in a low yield environment. 

Second, as long as we remain in this low-growth grind and out of recession, high yield will do well because many investors will increase risk to get returns. Even after Hurricane Harvey, corporate bond yields were going down. The average US investment grade corporate bond yield was almost down to 3% as August ended and Harvey was dissipating. That’s from 3.39% at the beginning of the year and a high of 3.5% in March. The average spread was just over 100 basis points. But the average spread of the BofA Merrill Lynch High Yield Master Index was under 400 basis points, a cycle low. Goldman is now coming out with an ETF to take advantage, the Goldman Sachs Access High Yield Corporate Bond ETF. Barron’s says:

The fund aims to offer “lower cost access to high yield corporate bond markets.” Priced at 34 basis points, it tracks the Citi Goldman Sachs High Yield Corporate Bond Index, which uses “a transparent, rules-based methodology, aiming to exclude those bonds with the greatest potential to default or deteriorate in price.”

Punters are also piling into emerging markets to get return.

“Despite the weaker economic momentum and more geopolitical noise, we expect the overall macro backdrop to remain healthy for emerging markets in the coming months,” Michael Bolliger and Lucy Qiu, analysts at UBS Wealth Management’s Chief Investment Office, wrote in a note. They’re overweight in high-yield emerging-market sovereign bonds.

As always though, caveat emptor! Reaching for yield to boost returns works until it doesn’t. When this business cycle turns down, duration plays will probably still work but the risk seeking return mentality won’t.

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