Franklin Templeton Fixed Income Group’s Christopher Molumphy thinks the Fed has truly earned its dovish reputation with its decision not to raise short-term rates at its September 16-17 Federal Open Market Committee (FOMC) Meeting. He explores what that move could mean for the fixed income market and explains why he thinks there may be little for fixed income investors to fear when rates do eventually start to move up.
Chris Molumphy, CFA,
Chief Investment Officer
Franklin Templeton Fixed Income Group
The US Federal Reserve (Fed) remained on hold at its September policy meeting, kicking the can on interest rates, but it is still likely to increase rates by year-end.
The Fed also updated its quarterly economic forecasts. US real gross domestic product growth was revised downward for 2016 to 2.3%, from a forecast of 2.5% previously in June.
With respect to unemployment, Fed policymakers were a bit more positive, but that’s because the data have improved dramatically over the past quarter. Their forecast for unemployment averaged 5% for the fourth quarter of this year, versus 5.1% today. The fourth-quarter forecast for next year averages 4.8%, a low for the cycle.1
It’s interesting to note that the Fed didn’t really adjust the forecast for full long-term employment much. And, in fact, the current unemployment rate of 5.1% is already in their range of “full employment.” With respect to inflation, the Fed did bring their inflation expectations down a bit and still believes inflation will remain at or below 2% through 2018. Lastly, the forecast on the federal funds rate—their short-term benchmark interest rate—is interesting. It calls for rates to move higher by the end of this year (although down from June’s forecast of 0.6%), and rise to 1.4% by year-end 2016 and 2.6% by the end of 2017.2
When we look at all the data and the updated forecasts, combined with commentary from Fed Chair Janet Yellen following the meeting, this Fed seems to have earned its dovish reputation. We expect to see the Fed very likely to err on the accommodative side in the foreseeable future.
Fed’s Deciding Factor: Inflation
With the US economy at or near full-employment levels according to the Fed’s own model, clearly the deciding factor in the mind of the Fed seems to be inflation. A federal funds rate at zero with full employment otherwise wouldn’t be appropriate. The Fed seems to be fixated on a target inflation level of 2%, looking primarily at core and headline personal consumption expenditure (PCE) data. Headline PCE is running close to zero year-over-year, while core PCE (which excludes food and energy) is running at about 1.2%, which is still a very low level. In our view, core is a better indicator because it does remove the impacts of energy, which has been volatile, so to us it’s a better predictor of forward-looking inflation. Energy, even in the words of Yellen, is likely to be transitory in its ultimate impact on inflation. We think the price of oil is likely to cycle through as we move toward year-end and hence the core indicators of inflation should be better predictors going forward.
Yellen did admit that inflation acts with a lag, so the Fed cannot wait until inflation actually hits its target to begin raising rates. As we look forward, clearly inflation appears to us to be the primary factor that’s driving federal funds rate policy over the near term.
It’s interesting that the Fed’s formal mandate is very much a domestic mandate: employment and inflation. However, global factors can impact portions of that mandate. They can affect growth, primarily through the export market. They also can impact inflation through import pricing and through the relative strength of the US dollar, which I think is what we are seeing. It’s notable that one of the few changes to the Fed’s statement from the last policy meeting is a reference to global developments this time around as a factor that may restrain economic activity and put further downward pressure on inflation in the near term.
Clearly global events are a factor for the Fed, particularly the volatility we saw in the markets during August. In our view, continued global volatility in the months ahead is likely, and that may continue to impact Fed policy in the coming months, potentially further delaying initial liftoff.
However, there are significant portions of the global fixed income marketplace with central banks which are still actively operating easing programs, including Japan, Europe and most recently China. We think the global interest rate environment will as well work to help keep interest rates low in the United States. Broadly speaking, we may well be moving away from the current focus on rising rates and more toward a focus on a lower global rate environment—not necessarily lower than we are today, in the case of the United States, but still low compared with where rates have been historically.
Rising Rates: Maybe Nothing to Fear?
We are looking at a number of themes internally that we don’t think are discussed in the popular press. One of these would be the concept that raising rates might be a positive for the bond market. We admit we were a little disappointed the Fed didn’t take action at the September meeting, primarily because we think the longer the Fed stays on hold, the longer we will have uncertainty in the marketplace.
However, we think it’s only a matter of time before the Fed moves off the zero bound and, quite frankly, we would like to see the uncertainty removed from the marketplace. While past performance is no guarantee of future results, historically, once the Fed has started raising interest rates, rates tend to be reasonably stable afterward. So we don’t think a rate increase will necessarily be that negative for the fixed income markets in general.
There is also a notion that inflation is too low, but it has been my view that low inflation over the longer term is a good thing. Of course, deflation is something that financial markets want to avoid, and in 2010, arguably there was a potential—not a large one—but a potential for deflation that the Fed needed to be mindful of at that time. But clearly in today’s markets, more than six years into an economic cycle with unemployment near 5% in the United States, I don’t see deflation as much of a risk.
We don’t think the fact that inflation running at 1.5%, plus or minus, rather than the 2% the Fed is targeting, is a major deal. When we look at inflation, we focus on core inflation as most economists do, because we think it is a much better forward indicator. As the decline in oil potentially cycles off toward year-end, headline inflation will likely move up and migrate toward core inflation. Additionally, we are starting to see wage inflation ticking up in the United States, and that tends to be the bigger driver of inflation. Hourly wages are now rising at roughly 2.3% on a year-over-year basis. This whole notion that inflation is too low and is a major problem is one we don’t generally agree with.
A Fed that’s going to remain extremely accommodative will impact our investment approach as we look at the fixed income markets going forward. We think a fairly constructive environment for corporate credit should remain, favoring investment-grade or high-yield corporates, and/or bank loans. We could see continued volatility in the markets over the coming months, so diversification3 into multi-sector portfolios makes a lot of sense, in our view. With a more accommodative Fed, we think longer-duration assets like municipal bonds could also likely perform pretty well over the foreseeable future because interest-rate risk on the longer end is probably a bit diminished after Fed actions today.
The media focuses on when that first rate rise is going to come, but as Yellen referenced, it is much more important to think about the trajectory of future increases in the federal funds rate over the next two or three years. We would agree with the general market view that the trajectory is going to be very gradual, so short-term rates as well as longer-term rates should remain low for some time.
Volatility and the Importance of Active Management
Passive management in fixed income has, at times, outperformed in periods of low volatility combined with bull markets. And let’s face it, we’ve been in these periods broadly speaking for both equity and fixed income markets; for equity markets that’s been the case for more than six years, and for fixed income markets, it has been several decades. Having said that, when volatility increases and markets become more difficult, active management has had more opportunity to shine and, we think, has an advantage as we look forward. The average investor is often unaware of the interest-rate risk that comes from investing in a passive, index-based product. The duration on the Barclays US Aggregate Index, a common benchmark for passive strategies, is roughly five to six years.4 We think that is a lot of interest-rate risk.
Additionally, passive strategies often are blindly buying the components of the index due to their investment mandates, regardless of a company’s fundamentals, or in the case of global products, the country or the yield on the underlying securities. There are countries where yields are actually negative today, but whose securities are still purchased because they reside in an index.
The comments, opinions and analyses are the personal views expressed by the investment manager and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The information provided in this material is rendered as at publication date and may change without notice and it is not intended as a complete analysis of every material fact regarding any country, region, market or investment.
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What Are the Risks?
All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. High-yield bonds and floating-rate loans are generally lower-rated, higher-yielding instruments, which are subject to increased risk of default and can potentially result in a loss of principal. Because municipal bonds are sensitive to interest rate movements, an investment portfolio’s yield and value will fluctuate with market conditions. Global and foreign bond risks include currency fluctuations and political uncertainty.
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