Fixed Income Outlook: It's all about employment

Federal Reserve Chairman Bernanke continued his real-world laboratory experiments with a powerful dose of quantitative easing in an effort to boost the slow growth U.S. economy. The Fed gave the market everything it was anticipating and more, including a commitment to: keep short-term rates low for at least another six months, until mid-2015; repurchase $40 billion per month of agency mortgage-backed securities (MBS); and perhaps most significant, an open-ended pledge to continue these actions until employment improves “substantially” and surprisingly, even after improvement is noted.

Clearly, Fed Chairman Ben Bernanke and company are going to do whatever they can to keep rates low, particularly on the short end of the yield curve and particularly in mortgages, where via new quantitative easing and agency MBS purchases already in place, they are buying up the bulk of supply. The Fed is deemphasizing its dual mandate—price stability and full employment—and is focusing almost solely on job growth. This is unchartered territory from recent years as they have said they want to see inflation come in above their current long-term target of 2%.

The grand experiment
With the Fed pouring fuel into a housing market that is starting to turn—home sales, prices and starts all appear to be in a sustainable move up—the question becomes, “Can policymakers douse the flames in time to keep future inflation in check?” This is the potential risk that has many fixed-income participants concerned, ourselves included. If the Fed overestimates its ability to get back on the other side of this trade, i.e., to tighten and deflate its balance sheet quickly enough to keep inflationary expectations in check, fixed-income investments could experience significant damage. It’s the old toothpaste-back-in-the-tube, genie-out-of-the-bottle conundrum, with Bernanke essentially saying he will be able to put the toothpaste or genie back when the time comes. But history is rife with examples where policymakers overestimated their capabilities.

Underlying the Fed’s historic intervention is a chairman who did the bulk of his academic work on the Great Depression. Bernanke appears to believe the biggest risk is a fallback to a major double-dip recession/depression, and he’s going do what he can to prevent that at all costs. This is the grand experiment. What the Fed really seems to want is for fixed-income investors to invest in the real economy, so it’s buying up a disproportionate share of the government-supply market, either through Operation Twist or the newly announced MBS purchases, leaving fixed-income investors with almost no choice but to buy spread products. This is a major reason high-yield, emerging-market and investment-grade corporate bonds experienced strong rallies in the past year. This is also why we have remained overweight in these sectors, and in MBS (this latter clearly being a case of ‘Don’t fight the Fed.’)

Don’t overstay our welcome
That said, we have become more defensive, lowering our positions in each of the credit sectors to modest overweights or neutral positions. There are enough crosscurrents—the mess that is Europe, questions about the pending elections and fiscal cliff, corporate uncertainty that’s hampering hiring and investment—to warrant taking a little bit of risk off the table. We think there is some risk toward higher rates, partly because real rates remain negative (the nominal inflation rate continues to be higher than the 10-year Treasury yield) and partly because of the Fed’s stated desire to see inflation go even higher the next 12 to 18 months.

Moreover, given that returns have been strong, we don’t want to overstay our welcome in spread products. The return profile is getting a little long in the tooth, i.e., the trade is getting crowded—everyone wants to be there—and we’ve seen what happens to assets when everyone wants them. Finally, given the uncertainty out there both on the domestic policy-election front and in Europe, our fixed-income team felt it prudent to hedge its bets a bit. The big macro play remains in place—a full index position in credit —and the Fed is supporting that. But we want to be ready and able to make a move if event risk enters the picture or if the market gets a whiff of credit concerns.