There have been two conversations going on at the Federal Reserve this summer.
The first, not surprisingly, has been the timing of the next rate hike. As job growth has rebounded and Brexit risks have subsided, some participants within the FOMC have begun to signal a rate hike as appropriate by year-end. At the same time, another discussion is taking place that is gathering a lot of attention. Specifically, is the Fed prepared for the next recession and how should monetary policy operate efficiently in the longer run?
With growing acceptance amongst academics and investors that interest rates and growth will remain lower for longer, the question has become what policy makers will do to stimulate growth next time around when interest rates are already very low. The Fed appears to be at an inflection point in its policy regime as it is being forced to contend with cyclical (less responsiveness of wages & inflation to diminishing slack) and structural issues (think demographics, productivity, regulations, etc.).
The market is now waiting for clarification on these two conversations. This clarity could come from Chair Yellen on Friday at the Jackson Hole conference. The theme of the conference this year is “Designing Resilient Monetary Policy Frameworks for the Future” and the title of Yellen’s speech is “The Federal Reserve’s Monetary Policy Toolkit”. What Yellen will address may or may not satisfy the market’s curiosity. Our view is that investors are more likely to get a detailed discussion on the latter (long-run policy discussion), rather than the former (current policy expectations).
Investors will likely be dismissive of Yellen’s cheerleading of the US economy’s resilience and the economic progress made since the Fed first raised rates in December 2015. Markets will also likely gloss over any discussion of the existing monetary policy tool kit: interest rate policy, quantitative easing/large scale asset purchases, and forward guidance/communication. Yellen will likely communicate confidence that these existing tools will be sufficient in most cases to stimulate the economy.
A large emphasis on the need for complementary fiscal policy will also likely be incorporated into her message. Since monetary policy can only act within the confines of the long run neutral interest rate (R*) which is set exogenously, a discussion of structural reforms that can be done to raise R* and reduce this constraint on the central bank will likely be considered. We’ve already received glimpses from Williams, Dudley and former policy makers on this topic.
Next will come a discussion of what the Fed can do beyond these existing tools. To minimize the constraint of the zero-lower bound and lower real rates further, the Fed could consider raising the inflation target, price-level targeting, or nominal GDP targeting. If price-level or nominal GDP targeting is introduced, it will likely be in a theoretical rather than a practical way. Since these policies have never been implemented before at any central bank (with the exception of the Riksbank’s brief implementation of price level targeting in the 1930s) and the Federal Reserve operates on a slow moving consensus, Yellen’s speech is unlikely to include any official announcement or endorsement of an imminent change to the Fed’s current framework and 2% inflation target.
What would really pique investors’ interest would be a discussion of the impact of her analysis on current monetary policy. This discussion may or not may not occur at this engagement. If the conversation does not happen, we would view this as a missed opportunity by the Chair. Investors are expecting a clear roadmap as the Fed transitions to a new policy framework.
Near term policy action and the longer-run framework at the Fed are currently separate issues for the FOMC. However, at some point these views between what is appropriate by year-end and the “longer-term” will need to converge. This convergence will define the path of policy for the remainder of the current cycle, shaping how yields and the curve behave over the medium-term. The Chair has an opportunity to reconcile the current time-varying policy objectives being considered by the FOMC and provide the market with some much needed clarity.
U.S. corporate pension plan sponsors, like many others, have been waiting with varying degrees of patience for the much-anticipated increase in interest rates from historic low levels. Unlike investors who hold fixed income for portfolio diversification, liquidity and safety, many corporate pensions hold long duration fixed income as a hedge against the present value of their liabilities. While traditional wisdom states that longer duration investments will underperform shorter duration strategies when rates increase, this may not necessarily be true for pensions in the near future.
Several factors, including the 2000-2002 and 2008 “perfect storms” for pensions which saw growth assets (like equities) fall at the same time as interest rates decreased, have led pensions to the following two conclusions: 1) they would like to be de-risked and hedge or offload their liability exposures at some point in the future, and 2) now is not the time to change from a growth-focused asset allocation to one that is fully de-risked. This has helped spur the popularity of de-risking glidepaths, where the asset allocation gradually moves towards de-risked under certain pre-determined conditions, with funded status trigger levels being most common. Since the majority of pensions have not yet reached their ultimate de-risking objective, they are sitting on the sidelines waiting for rates to rise so they can allocate more to long duration. This also means that the majority of pensions have not fully hedged their liability exposures, so they will still benefit from rising interest rates.
Pensions will eventually buy more long duration but many are holding off on doing so now and some are considering shortening the duration of their fixed income allocation in anticipation of higher interest rates in the future. While there is much debate surrounding the timing and extent of future rate moves, the market consensus seems to be that any increases will be very gradual and the long end of the Treasury curve will not increase as much as the short end. The short end of the curve is typically more directly linked to Fed rate hikes. But the long end of the curve is likely to be more driven by factors such as economic strength, inflation expectations, and demand for long duration bonds. These factors will act as an anchor on the long end, especially in light of the expected future demand from pension de-risking programs.
Given the status of pension de-risking programs and the current market environment, it’s interesting to examine the potential performance of fixed income benchmarks commonly used by pensions under different rate scenarios. Figure 1 illustrates the expected performance of the Barclays Aggregate, Barclays Long Government/Credit, and Barclays Long Credit indices in parallel curve shift scenarios. The left chart shows returns for curve moves over a one year period and the right chart shows cumulative returns for curve moves over a three year period. As expected, for large enough rate moves, the long indices underperform the Aggregate index. But the Long Credit index outperforms the Aggregate for a +25 bps curve shift over a one year period. Over three years, both Long Government/Credit and Long Credit outperform the Aggregate for a +25 bps curve shift while Long Credit also outperforms for a +75 bps curve shift.
Since future rate increases are expected to be accompanied by curve flattening (bear flattening), this should help to bolster the long duration performance relative to the Aggregate. As illustrated in Figure 2, both long indices are expected to outperform the Aggregate for an increase of 50 bps in short rates and no change in long rates over a one year period. The Long Government/Credit index is expected to outperform the Aggregate for an increase of 100 bps in short rates and 25 bps in long rates over a three year period. And the Long Credit index is expected to outperform for an increase of 150 bps in short rates and 50 bps in long rates over three years.
The reasons for the relative performance between these indices are the index characteristics as well as the current and expected future path of interest rates. As of July 31, 2016, the duration of the Aggregate, Long Government/Credit and Long Credit indices was 5.5, 15.7, and 14.1, respectively. Their respective yield to maturity was 1.87%, 3.22%, and 4.00%. Since the main drivers of investment grade fixed income returns are yield and duration, the greater yields of the long duration indices can help to offset any negative duration impact of interest rate increases. This is especially true if rates at the long end of the curve do not increase as much as shorter rates and the increases happen slowly over time, as is generally expected in the future. One caveat to the returns summarized in the Figures above is that these only consider changes in rates and do not include any changes in spreads. However, it makes sense that the Fed likely will not proceed with implementing multiple rates hikes if the economy and corporate America experience significant pain (and spreads correspondingly widen significantly).
Each of the indices noted above can play a role in a pension’s asset allocation. With many asset allocations expected to include a greater allocation to long duration in the future and there being uncertainty over the path of future interest rates, timing the market to pick the optimal point at which to extend duration looks to be a challenging task. Tactical adjustments can be made to the portfolio duration as long as this doesn’t act as an impediment to the implementation of the long-term de-risking strategy. And, even if rates do rise as expected, pensions shouldn’t be too fearful of holding long duration and increasing this allocation according to previously approved de-risking plans.
De-risking is a general term referring to strategies that aim at reducing the risk exposure of plan sponsors to their pension fund; however the term in no way implies the removal of risk.
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