CIO
Matthew Diczok and Meghan Swiber
Bank of America
09/28/22
11:30 am ET
Matthew Diczok: Thanks very much for joining everyone. I’m Matthew Diczok, head of fixed income strategy for the Chief Investment Office. Today is Wednesday, September 28 and I’m happy to be here with Meghan Swiber, who is our senior rate strategist from BofA Securities. Meghan, thanks so much for joining me today.
Meghan Swiber: Thanks so much for having me, Matt.
Matthew Diczok: So, what we want to talk about today is obviously all the changes and the opportunities in the fixed income markets and specifically how we think the Federal Reserve is going to try to combat the inflation problem and what that means for bond markets for our clients. Obviously as we said, it’s been an incredibly challenging time with high inflation. Obviously high inflation is difficult for all financial assets, both stocks and bonds but again lower prices lead to higher future returns in our opinion and so there are definitely opportunities here specifically as we look at the bond market with much higher nominal and real yields, meaning yields both with and without inflation accounted for. Meghan, as we look at the past couple of years, obviously various economic theories go in and out of style and one of the economic theories that went out of style is what we call “monetarism.” Basically, the idea that ultimately inflation is primarily a monetary phenomenon and that hasn’t been popular for over three decades now because changes in the money supply really haven’t had any correlation to inflation. Now unfortunately, if you took that idea too far that no amount of monetary supply will affect inflation, you wind up in a very different place and the combination of what the Federal Reserve did in terms of buying of a lot of bonds to put on their balance sheet and the federal government increasing deficits massively helped increase money supply to almost 30% year-on-year when the average money supply growth for three decades was probably about 5% on average approximately. As the Chief Investment has been pointing out, that level of fiscal and monetary support for markets was not an amount of accommodation that we have seen since World War II. This was literally a wartime level of policy response. Unfortunately, that combination of both Federal Reserve and federal government policy which was necessary to help deal with a pandemic and necessary to get us through and get the economy through a very tough time had some inflationary outcomes. Now the Federal Reserve has a dual mandate as we call it: they’re here to keep jobs at a maximum employment, and they’re also here to keep inflation at around 2%, what they call price stability. It feels very much more now that they’ve got a single mandate. They just really have to deal with the inflation problem which was caused again by money supply growth, fiscal deficit and supply chain disruptions, things out of their control but in terms of what is in their control, what is the Fed doing right now, Meghan, in your opinion, to try to accomplish that goal of reducing inflation?
Meghan Swiber: Sure, Matt. First and foremost, the Fed still does have the dual mandate but both components right now are pushing them to raise rates to slow the economy down. Inflation is the obvious glaring problem here but unemployment is also below those longer-run levels. So, in order to address the inflation problem, the Fed is set out to rebalance the labor market. We hear that often in a lot of policy makers comments which is really just a nice way to say that unemployment will need to move higher. This cools the demand side the inflation problem and does help the Fed achieve price stability, but the question really comes down to, how does the Fed ultimately do that, right? Well, they raise rates which we’re seeing some signs of in passing borrowing cost already and that helps slow lending and credit creation down, and eventually serves to cool down the economy.
They’re increasing rates through two channels really. The first one is raising the policy rate which increases those shorter-term borrowing cost and the second component as discussed is reducing the size of the Feds’ balanced sheet through quantitative tightening, that increases the supply of Treasuries in the market which also increases those longer-term borrowing cost. Higher rates also cool things off from an investing perspective, so some of these comments that you were making upfront, Matt, the Fed calls this impact, generally, the portfolio balance effect. Because Treasuries are currently yielding levels that are historically attractive, investors think twice about putting their money in those riskier assets so think equities, credit products. We’ve begun to see signs that investors are moving down that risk spectrum towards safer haven assets given inflows that we’ve begun to see in shorter-term government funds. This reallocation when it happens in mass away from those riskier assets more towards risk free assets means the risk premium of those riskier assets effectively increases. The riskier assets like credit and equity need to cheapen to look more attractive which means that businesses are paying up to finance business operations and new projects. And that helps slow down growth and cools the economy ultimately what the Fed needs to do to get inflation under control.
Matthew Diczok: Got you. So, one of the things that’s been really affecting markets is the change in expected Fed policy with respect to the short-term interest rates. So, they manage a targeted short-term interest rate, the Fed funds rate, you and I were talking a year or so ago. Then, by the beginning of next year, the market has expected that rate to be somewhere in that zero to 50 basis points range, and that has increased dramatically, where it recently, almost came up to the 5% range. So, that huge change in what the Fed was expected to do with rate has flowed through all long-term rates in the market, and also through stocks as well. So, obviously, the market has now gotten a sense that there is a much higher path for short-term rates, and hopefully, the expectation for the market and the Fed are on a similar page right now. So, Meghan, where do you and the team see the Fed taking its rate policy in the next year or so?
Meghan Swiber: Sure, Matt. So, just kind of taking that step back, really, what surprised us on the economic side, what surprised Fed officials, what surprised the market overall is just how strong the U.S. economy has been. And really, what that means is that the Fed needs to do more work, raise rates higher to cool it down, to get inflation under control. In terms of what we’re expecting, we have the Fed continue hiking. We’re expecting them to deliver another super-sized 75 basis point hike in November, followed by a 50 basis point rate hike in December, and then two 25 basis points hikes next year, in February and March. This will put the terminal rate between 4.75 and 5%, which is – you know, it certainly is historically elevated versus what we’ve seen from the Fed over the past 20 years or so. And ultimately, we think this will help do the work to cool the economy down. Again, really, what’s just been so surprising is how strong the U.S. economy has been. And as that data surprised to the upside, that just caused Fed officials, the market to reprice those expectations higher. So, there’s still a lot of uncertainty around where that rate is going to be, but given what we’ve already seen in terms of the rate moving higher across those longer-term borrowing costs, we think that’s doing the needed work to cool the economy down and get inflation under control.
Matthew Diczok: Got you. So, you had mentioned that the Fed obviously, has effectively, two tools that it’s using right now to help combat inflation. One is the rate policy we just talked about, and you also referenced quantitative tightening. Now, we did write about this in a client-approved piece called “QT or not QT, that is the Question.” So, we’ve been highlighting to folks that again - the Fed refers to the initial policy, sort of large-scale asset purchases, what we refer to as quantitative easing, which is the Fed buying bonds from the market, reducing rates, hopefully encouraging more risk-taking, encouraging more borrowing and lending, and now, they’re doing the opposite, what we all colloquially refer to as “quantitative tightening.” The opposite of a large-scale asset purchases where they sell Treasuries back in the market or more accurately, let bonds roll off their balance sheet back to the market and don’t reinvest proceeds. Basically, their balance sheet shrink, that gets more Treasuries, and more mortgage-backeds in the market and removes bank reserves from the market. So, how does QT work from your opinion, and how does that fit into the Fed’s framework for monetary policy?
Meghan Swiber: Yes, great, Matt. That was a nice summary, I would say. So, QT, again, quantitative tightening is when the Fed is shrinking its balance sheet. We’ve obviously seen the Fed grow the balance sheet to this incredibly elevated size, and they did this by buying trillions of dollars of Treasury securities, as well as mortgage-backed securities. So, what they’re doing now, consistent with their policy framework of trying to tighten conditions, is letting that balance sheet run off. And as you mentioned, Matt, they’re not doing this by necessarily selling assets into the market. Instead, they’re letting securities mature. And the way to think about this kind of taking a step back.
So, if the Fed was trying to maintain the size of its balance sheet, what would happen is when they get up a paydown of Treasury securities, just as any owner of bonds does, right, they get that principal payment back, if they were to try to maintain the overall size of the balance sheet, what they would be doing is reinvesting that principle back into the market. They would be effectively going back to Treasury and say, “No, you keep this money. I’m going to keep holding those Treasury securities.” But instead, what they are doing now is taking that payment of principle from Treasury, and also letting those mortgage back securities mature as well.
Now, in order for Treasury to pay the Fed back that principle, what Treasury actually needs to do is turn back to the market overall and issue more debt. So, with this changing of hands between securities that the Fed owns on their balance sheet, to now, what the market overall needs to absorb. And this of course is increasing the amount of Treasury securities, mortgage-backed securities that are in the market. Of course, that higher supply basically means that rates need to clear at the higher level as well. And this is the way they can impact borrowing costs, not just at the very front end of the curve, but also at those longer maturities. Basically by increasing the supply of that Treasury debt that the market will now need to take down. And again, kind of coming back to this main point, those higher borrowing costs are really how the Fed is able to transmit monetary policy to the real economy.
Matthew Diczok: That’s a really helpful update. That puts it in great perspective for clients. As we try to put all this together, obviously, the Fed is directly responsible for setting some short-term policy rate in the mark. They don’t effectively change long-term interest rates directly, but everything they do with rates, with policy does have an effect on longer-term rates. Again, the expectation of higher short-term rates has dramatically changed the picture for long-term rates both in Treasury securities and in all sorts of other bonds; corporate securities, high-yield securities, et cetera. How do you and your team see the path for longer-term interest rates to react in the coming years?
Meghan Swiber: Sure. Right now, the story is very clearly on what the Fed needs to do to get inflation under control. While we all think they’re probably going to top out at around 5% on the fed funds rate, no one knows for sure what that rate level needs to be. And the Fed doesn’t know exactly where that rate level needs to be either. You actually can see in their own projections across all of the monetary policy variables that they’re forecasting, the economic forecast that they have, they’re at maximum uncertainty across almost all of those components: unemployment, inflation, GDP growth. That’s because they have this very hard job to do right now to get inflation under control and cool this economy down. Right now, the level of rates across the entire yield curve, as we call it, across all the maturities, is really dictated by how high the Fed is going to have to bring that policy rate. You see that as you mentioned that, really all of those maturity points move based on those expectations for how high the Fed is going to have to take the overnight rate. But at some point in time, we’re going to see this pivot. This is because in order to get the response the Fed needs on inflation, again, what do they have to do? They have to raise unemployment, and they risk sending the US economy into a recession. Actually, that recession is our economists’ base case forecast right now. It’s this unfortunate toll that the economy basically needs to pay to get prices back under the Fed’s control. So, how does this impact the yield curve? For now, again, everything is really moving based off of the overnight rate, but over time, once the Fed begins to see signs of the economy is cracking, that we see unemployment moving higher, that we see those monthly nonfarm payrolls prints turning negative, that’s the point in time we think that longer-term rates are going to begin to move down and become more dislocated from where those shorter-term rates are. Because the market needs to price the impact of what the Fed’s currently doing to get inflation under control at those longer-term maturities. Usually, again, when you find the economy in this shift moving towards this slow-down period, this period of economic uncertainty and recession, the first thing many investors want to do is sell those riskier assets and buy those safe-haven assets that we’re talking about, right, buy Treasury securities, and that helps put the downward pressure on those longer-term Treasury maturities and ultimately will reflect this pivot in terms of the economic outlook for the economy in terms of the Fed needing to just be myopically focused on inflation to then begin to see what the damage is being done on the employment front as well. So, kind of moving back to this dual mandate focus instead of just being so very narrowly focused on what they need to do to get inflation back under control. So again, right now, I think we’re going to be continuing to see a lot of volatility in those rates across the whole Treasury yield curve because of that concern and uncertainty around where the Fed overnight policy rate needs to be, but overtime, once we do begin to see those cracks, you’re going to have those longer-term yield levels move back down to what we think is more consistent with longer-run averages around 2.5% or so.
Matthew Diczok: Got you. That’s extremely helpful. So, you talked about some of those potential cracks in the market. You mentioned more volatility markets. Obviously, one of the byproducts, intended of the Fed’s accommodative policy over the past several years, was actually to dampen volatility in markets and to reduce volatility in markets just by virtue of having another very large, very price-insensitive buyer of securities in the market that does dampen inflation. Now we see is they start to remove the accommodation from markets. We’re seeing volatility in markets – not here, but globally. So, when you and your team look at what the Fed is doing and how markets are reacting, what sort of signposts will you look for to tell us if the Fed is actually going too far in restricting/tightening policy? What cracks in the markets, to use your words, would you be looking for?
Meghan Swiber: Right. So, this time around, Matt, the Fed has this difficult job ahead of us, and I don’t think that there’s really this – a lot of people in markets call the “Fed put” where there’s a certain level of an equity drawdown that the Fed will not be able to tolerate. The Fed needs to engineer the slowdown which is done through the tightening of financial conditions by seeing those equity risk premiums rise. That’s the job that they’re looking to accomplish here. So, I would say that when we’re looking at financial markets, when we’re looking at the movements that we’re seeing everyday in equities and the credit market, there’s not necessarily this line in the sand that they’re going to look at and say, “Okay. Our job is done.” Instead, what they’re going to be looking at to say, “Our job is done,” is in the real economy. It’s actually being able to see the demand component of inflation show signs of cooling, show wage pressures moderate, see unemployment move higher. The tricky thing about all of this is that those signals that they need to get from the real economy take time, and it takes a longer amount of time for this Fed to see those signals than what we’re currently observing in financial markets right now when we’re looking at the movements in equities and credits and rates. This is why in our view it’s going to be very hard for the Fed to avoid this recession outcome because they have this – the things they’re most focused on will take a longer time to turn than the indicators that we see right now in financial conditions. To us, this means that there’s probably a lot more pain that the market needs to endure on the equities front, on the credit front, riskier assets in general, before the Fed sees those signs in the real economy that they need to say, “Our job is done here.”
Matthew Diczok: Excellent. That was really helpful, Meghan. Thanks so much for joining us today. I really appreciate your comments.
Meghan Swiber: Such a pleasure.
Matthew Diczok: From our perspective, there are two main points we’d like clients to take away from this conversation. First off, remain diversified both across asset classes and within fixed income. Now, fixed income can help diversify portfolios mainly in two ways. First, bonds may go up in value when stocks go down. That’s not a certainty but it’s possible. Secondly, high-quality bonds can provide steady, reliable income, and by high-quality, we mean US Treasuries, agency mortgaged-backeds, investment grade corporates and municipals. Higher yields give a greater likelihood to both those type of diversification being possible in our opinion. Higher yields make it more likely in our opinion that yields can decline and prices can go up if stocks decline. Secondly, higher yields do give you that more steady and reliable income. So, while we always feel it’s important for clients to be diversified, it is particularly important in our opinion to be diversified and include fixed income in most portfolios in this environment.
Secondly, we’d like clients to work with their advisors to make sure that the maturity of their bonds is suited for both their risk tolerance and their investment goals. Working with your advisors to figure out what average maturity of bonds is right for you and your portfolio is critical, and not straying too dramatically from that average maturity, what we call duration, without proper planning or forethought makes sense, because if there is a very large difference between your investment timeframe and the maturity of your bonds, that may, in our opinion, make your goals actually more difficult to achieve. For example, abandoning a long-term fixed income portfolio and going 100% into cash for example would make your investment goals generally harder to achieve in our opinion. Now that the market is at significantly higher yields than we’ve seen, generally higher yields than we’ve seen in a decade or more in our opinion, they may be able to deliver returns greater than inflation over longer periods of time, in our opinion. Although, again, nothing is certain. For example, Treasury Inflation-protected Securities right now are trading at positive real yields. Meaning, that they will deliver additional yield over consumer price inflation when held to term. Now, that’s a significant change in markets in our opinion, as they were at negative real yields for a good portion of 2021 and 2022. So, staying diversified and making sure that the maturity of your bond portfolio matches your investment goals or risk tolerance, is critical.
Thanks so much for joining us. We look forward to speaking with you next time on the Chief Investment Office Interview Series. END
5010226 – 10/18/2023
