If you listened closely after the US Federal Reserve’s surprising September policy announcement, you might have heard confused investors around the world saying, “Ben, you’ve lost us.”
Fed Chairman Ben Bernanke reported that the US central bank had chosen to keep its $85-bn-per-month quantitative easing (QE) programme intact, a decision that starkly contrasted with the strong signals it sent in May that it would start winding down the open-ended QE effort that it had begun only nine months earlier.
US GDP growth, employment and inflation numbers have all been relatively consistent for the past year, so the seemingly wide swings in policy stance during that period have left the market with big questions about the Fed’s future direction.
Bond investors need to rapidly come to terms with this new source of market uncertainty, find ways to build portfolios that mitigate these new risks and take advantage of opportunities stemming from increased volatility when they present themselves.
Before we start parsing the Fed’s recent announcements, it is important to note how the signalling effect works within the Fed’s policy statements. The theory goes that if the market knows the Fed’s intentions, it will do some of the Fed’s work for it. For example, if the Fed says it plans to gradually cut rates over the next few years, businesses may start to ramp up hiring and spending well in advance of the actual rate cuts.
The market doesn’t really need to know exactly what the Fed will do with interest rates, but it does need to understand the general rules of how economic events will trigger Fed action. If we know, for example, that the Fed will hike rates when inflation rises above a certain threshold, we worry less about the Fed’s monthly announcements and focus simply on trying to forecast inflation.
It’s exactly those rules of engagement that have been blurred by recent Fed decisions. In September 2012, the Fed announced a new open-ended QE programme that would continue until the economy achieved specific targets for inflation (2.0 to 2.5 per cent) or unemployment (6.5 per cent). This sent a clear signal to investors that they could build their Fed scenarios around their economic projections for inflation and unemployment.
Then in May 2013, the Fed reversed course and announced that it would likely start tapering its bond purchases “later this year”, with an implication that tapering could begin in September. The market was taken aback by this announcement, as neither inflation nor unemployment had come close to hitting the Fed’s previously stated targets.
Finally, we heard in September that the Fed would leave its QE programme unchanged. Once again, the change in direction was not triggered by any big changes in economic data – if anything, data since May has progressed toward the Fed’s original goals, with a bump in inflation, a drop in unemployment and healthy results in manufacturing activity.
Since the Fed’s vacillations over the past year weren’t consistent with any shifts in the economic data they claimed to be watching, the market no longer knows what data the Fed thinks is important. Was QE3 designed for some other, non-stated purpose – to depress the dollar, or to offset fiscal budget tightening, or to buoy the stock market? Does the Fed see risks that it is not articulating publicly? We just don’t know.
Complicating all of this further is the fact that Federal Reserve Chairman Ben Bernanke is retiring in January, and President Obama has yet to nominate a successor. Investors need to be prepared for a wide range of 2013 outcomes, but also need to consider that Bernanke’s successor may chart a different course entirely for monetary policy in 2014 and beyond.
It all adds up to a market with no true compass for how Fed policy and economic reality interact, so we believe that the market’s recent spike in volatility and sensitivity to economic news is likely to become the norm rather than the exception going forward.
Building an investment thesis around the Fed’s short-term moves may be more difficult now, but it has always been difficult. We build our portfolios on fundamentals: we focus on identifying a select group of sturdy bonds from stable issuers, with attractive upside potential. This provides opportunity for total return but also provides the relative stability of bonds that will do well when held to maturity.
While this is an all-weather philosophy, we believe that our approach is particularly well-suited for this market. Whether it acts in 2013 or 2014 or 2015, the Fed will eventually reduce its monthly bond purchases and begin to hike interest rates. Given that, we are focused on shorter-duration bonds, as we have been for several years, to mitigate the potential impact of rising rates on our portfolios.
The yield curve is also exceptionally steep at the moment, meaning that the yield gap between very short-term and longer-term bonds is unusually high. We have positioned portfolios to benefit from this yield gap narrowing. Finally we keep a constant watch for moments when volatility produces opportunity.
In US municipal bonds, for example, fund flows have been persistently negative for much of 2013, as investors have reacted to rising rates as well as isolated solvency crises in Puerto Rico and the city of Detroit. The downward pressure on municipals across the board has enabled us to buy favoured bonds at attractive prices. We expect similar instances of market dislocation – and resulting opportunity – as we go forward in this uncertain period.
On the heels of the Fed’s recent communication breakdowns, the outlook for the bond market is more uncertain. Now more than ever, it’s important to focus on the factors we can control, and be ready to capitalise on opportunities that materialise when the market is blindsided by factors that, for the moment, no one can see clearly.
Thomas DD Graff, CFA is Head of Fixed Income at Brown Advisory
This piece first appeared in Spear’s Magazine
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