When doves cry: Fixed Income investors might need to pivot too
ED GOARD, CFA 27-May-2019
The dovish pivot from the Federal Open Market Committee (FOMC) signals a fundamental shift in the way the Fed formulates policy under Chairman Powell’s stewardship. Historically, the Fed has moved slowly and methodically (some would say stubbornly) absent a crisis, yet the abrupt pivot in early January and ultra-dovish policy statement following the March policy meeting underscores a more sensitive reaction-function. This response seems quicker and perhaps more willing to glean input from the financial markets and is likely a result of being only 250 basis points from the zero lower bound.
So while financial markets seemingly cheered the Fed’s dovish stance, Chairman Powell also acknowledged not consistently achieving the committee’s inflation objective is a disappointment, and having downward pressure on inflation is “one of the major challenges of our time.” From a policy perspective, he points out, it is likely easier to fight inflation rather than deflation, particularly when overnight rates are half of what one would consider normal and the Fed’s balance sheet is more than three times the size it was prior to the financial crisis.
Nevertheless, the FOMC’s overall outlook on the economy remains mostly positive, but persistent low levels of inflation have also caused the Fed to rethink its strategy, the initial results of which we saw unfold back in the March meeting. Announcements included a lower dot plot (now zero rate increases in 2019), lower growth and inflation forecasts and a larger balance sheet, the combination of which put the exclamation point on “patience and flexibility.” The market’s interpretation was so dovish it went so far as to start pricing in an interest rate cut later in 2019. While a truly flexible, data-dependent Fed cannot rule this out, investors must also include a level of patience in their equation as a significant amount of future hard economic data would need to support that view. Many at the Fed, despite nearly 10 years of evidence to the contrary, continue to insist that low inflation is “transitory.” Furthermore, while the deflation/disinflation problem in Japan is often written off as an anomaly unlikely to occur elsewhere, Europe is now experiencing the same problems. Old biases die hard, and our expectation is that this will be discussed in depth at the annual Jackson Hole Symposium in August.
Not surprisingly, the Fed’s shift also necessitates that some fixed income investors pivot within their bond portfolios. At the beginning of the year, the INCORE strategies were generally underweight to investment grade credit, yet began to add back exposure early in the year after the Fed’s signal and have embraced a slight overweight allocation to intermediate BBB-rated corporate bonds. While valuations have become richer, fundamentals and technicals, including corporate supply, foreign demand and fund flows, remain supportive of risk. As a result, the INCORE team expects to remain positioned accordingly until these signals change. The team also sees opportunities in agency mortgage-backed securities as a source of additional carry relative to Treasuries.
Yield curve positioning and duration will be tactically managed to take advantage of incremental opportunities as they arise. And as always, we continue monitoring the FOMC meetings and comments, global economic data, inflation trends, U.S.-China trade negotiations, and the continuing BREXIT saga.