A strong start to the year begs the question: can it continue?
At the end of December, we discussed the value opportunities that have been created in the asset class after a significant price decline in 2018, subsequently sharing our views in our last blog post of the year.
Fast forward a few weeks later, and our optimism has apparently been rewarded: EM sovereign is up by 3.5% year-to-date as of 28-Jan-2019, and EM corporate is up by 2.2%.
While such recoveries are not unusual in emerging markets (Exhibit 2), the key question becomes “can this recovery continue?”
Carry is our good friend, but the path is never smooth
In fixed income, carry normally gives us a good start when forecasting returns. However in EMD, it is not always the case on a year to year basis (Exhibit 3), despite the fact that in the longer horizon total return tends to either be in line with or exceed the carry. What could potentially prevent us from earning the carry in 2019, or, in a more extreme scenario, what needs to happen for the asset class to post negative returns despite its carry?
Looking at EM hard currency sovereigns: the breakeven spread and US treasury yield have moved a lot higher. Taking the market levels at the end of 2018, for the sector to lose money over a 12 month investment horizon, US treasury yields need to go up by more than 50bps, while spread levels would need to widen further to more than 450bps – and these two movements need to happen concurrently during a 12 months horizon (Exhibit 4). This appears to be quite an extreme scenario in our view. Both spreads and US treasury yields are normally negatively correlated, and for the past 15 years, the EM sovereign spread has only shot beyond 450bps once, in 2008.
A few main risk factors that had hurt the asset class last year may wane in 2019 (Exhibit 5). Quantitative tightening and China/Trade war evolvements will keep volatility high, but re-synchronizing global growth, a dovish Fed and a more “normal” EM political agenda allow EM to rebound. There are also reasons for optimism when it comes to the technicals: after consistent outflows last year, we know that a lot of crossover and other investors now hold significantly reduced allocations to the asset class. Supply and demand picture is also looking more favourable this year given the lower net supply forecast.
Our base case scenario is a soft landing for the global economy in 2019. This should offer a more favourable macro environment for EMD than the one that existed through most of 2018. In addition, EM spreads and currencies have adjusted quite a long way in 2018, giving 2019 a good yield cushion to start with. With that being said, conditions are set for improved performance for the asset class in 2019.
Fed Watchers have had it “easy” the past few years. They have all been hyper focused on just one aspect of monetary policy: “to hike or not to hike rates”. The details were relatively “straight forward”. The direction for the Fed Funds rate was clear (higher), the magnitude of hikes (25bps) was accepted as a “given” and the timing was limited to essentially four opportunities per year (the other four non-press conference FOMC meetings were generally accepted by investors as off the table). This year will be different for a variety of reasons. The first relates to the business cycle and the current economic backdrop. The recent tightening of financial conditions in Q4 2018 has given the Fed the opportunity to take a “patient pause” conveniently at the same time in which they have reached the lower bound of their estimates of neutral for interest rate policy. This perceived inflection point by the market has now increased the pricing of tail risk rate cuts – a new consideration compared to years prior.
But beyond the standard economic considerations, the Fed has also voluntarily (and involuntarily) added to their already busy agenda of which we will discuss more below. So buckle your seatbelts because we will all need to adapt to a Fed that will not only be communicating more in terms of volume but also in terms of number of topics discussed and variables considered. Chair Powell will need to walk a fine line as he attempts to keep the US economy growing and inflation stable while addressing longer-term monetary policy issues and communicating with the market more frequently.
Press conferences will occur at all eight FOMC meetings.
We will get our first taste of this additional venue for Chair Powell to communicate to markets on January 30th at the Fed’s next FOMC meeting. Although the markets are not currently pricing in rate hikes over 2019, press conferences at every meeting do open the door to an “off-cycle rate announcement” – a new interesting twist that will move us away from our quarterly comfort zone.
The Board of Governors has formally announced 2019 to be a year of review for the Fed’s strategies, tools and communication.
In November 2018, a quietly published press release indicated that in 2019 the Fed “will review the strategies, tools, and communication practices it uses to pursue its congressionally-assigned mandate of maximum employment and price stability”. Part of the announcement included information about a new research conference on June 4-5, at the Federal Reserve Bank of Chicago, where findings and research will be presented.
So, what types of topics will be discussed? A variety of alternative monetary policy frameworks will likely be deliberated relating to how the Fed defines and attempts to achieve their dual mandate. For example, while the Fed currently targets 2% headline PCE, a variety of other strategies have been socialized in the past such as a price-level and nominal GDP targeting (see my blog from February 2018 for more details). While research shows these types of strategies benefit most at the zero-lower bound, the real possibility of a formal shift to one of these alternative strategies would have implications for monetary policy in the here and now and markets may start to anticipate this.
Balance sheet deliberations, research findings and maybe even a decision.
Let’s break this up into two sections: the short term and the long term. The short term agenda is arguably more complicated because the Fed has attempted to separate its balance sheet from the stance of monetary policy (i.e. how restrictive or easy policy is). Currently, the Fed views the stance of policy to be primarily influenced by their interest rate agenda. The FOMC will likely attempt to continue to keep balance sheet policy separate from interest rate policy. However, the building market narrative around the balance sheet likely means that they will be encouraged to, at the very least, do more research. Any further discussion of this topic in addition to any research findings published is likely to add to market volatility as well as influence the market narrative. Nevertheless, Powell has expressed in a variety of forums that he is not convinced that the recent market volatility in Q4 was driven by the balance sheet.
Either way, the Fed needs to start getting the public comfortable on where the balance sheet is heading. As we all know, the balance sheet will not be shrinking indefinitely – as our economy grows, currency demanded by the public increases and the balance sheet naturally grows in size to accommodate this. So here are a few numbers: the total asset size of the balance sheet is ~$4 trillion and total reserves are around ~$1.7 trillion (both required and excess) as of January 16th. A recent survey done by the Fed called the “Senior Financial Officer Survey” indicates the lowest level of reserve balances respondents (which represented two thirds of all bank reserves at the time of the survey) would be comfortable holding in aggregate amounts to ~$620 billion. This would suggest the lowest level of reserves for the whole banking system would be around $900 billion – $1 trillion. However, there is an even wider range of estimates across primary dealers, investors and economists for the right level of total reserves ranging from $750bln all the way to $1.5 trillion. Therefore no matter how you slice it, we are closer to the end than the beginning of normalization and the markets will need clarity on how this process will proceed. Even if the surveys are correct and we have some amount further to go before we reach a level in which reserves are scarce, the Fed may prefer to keep some buffer of reserves to allow them to continue to control interest rates through the current “floor system” which uses IOER to influence other short-term rates. The other option would be returning to a “corridor system” where rates are controlled by open market operations and reserves are scarcer.
To add even more to this discussion: in the longer run, once the run-off ends, the jury is still out on the composition of the balance sheet. Any follow-up on the surprise mention in the December FOMC minutes of “very gradual” sales of remaining agency MBS in order to get closer to all Treasury portfolio will have implications on that market. So will the decision to stick with the current policy of investing across the Treasury curve versus returning to a portfolio of only bills and short-term Treasury notes.
Additional appointments to the Board of Governors mean more viewpoints and speeches.
President Trump has appointed Chair Powell as well as three new Governors (Bowman, Clarida and Quarles) since elected however he still has two more spots to fill. A few nominees have come and gone without being confirmed including more recently Marvin Goodfriend and Nellie Liang. While the President’s picks have all been mainstream so far, Trump’s increasing criticism of the Fed could increase the risk of a more alternative candidate.
All told, 2019 will be a year of transition for the Fed and therefore for the market. This transition period will likely be accompanied by volatility as the consensus among both Fed members and market participants shifts and evolves as the year progresses. With this in mind, we are viewing the New Year as an opportunity to be more tactical in the US rates and inflation markets as the Fed’s strategy appears to be even more fluid then in the past.