Is the Fed’s “Longer-Term” View Short-Sighted? | Lord Abbett
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Economic Insights

The U.S. Federal Reserve has convinced investors it is serious about its longer-term goals. Now it needs to assure them it also has a handle on the economy’s current needs.

Read time: 3 minutes

To respond to the economic disruption caused by COVID-19, the U.S. Federal Reserve (Fed) rolled out its big countercyclical balance sheet policy guns in March (read our summary), and continued to pound away until mid-May. But for the past four months, policymakers have been silent as markets had received all the liquidity support they needed, as evidenced by how little the Fed’s balance sheet has changed since then (Figure 1), and the central bank turned its attention to finalizing a review on its longer-term goals.

 

Figure 1. Fed Balance Sheet Expansion Has Leveled Off After a Busy March and April

Weekly change in the U.S. Federal Reserve balance sheet, February 5, 2020–September 9, 2020

Source: U.S. Federal Reserve. Data as of September 9, 2020.

 

The Fed rolled out changes to the framework it uses to achieve those goals a bit sooner than expected, at its annual Jackson Hole meeting in August. The Fed tweaked the inflation-targeting framework to recognize explicitly that periods of inflation modestly above 2% were fully compatible with its mandate and that it could afford to be less pre-emptive in tightening monetary policy as the economy approached its estimate of maximum employment. In doing so, the Fed hoped to demonstrate that 2% average inflation was achievable and that it would provide sufficient support to permit economic growth to remain strong enough to reach potential output in the medium term.

As of now, it appears the Fed has convinced investors that it will be successful (unlike the European Central Bank or Bank of Japan). For example, long-term inflation expectations have been moving higher since the Jackson Hole meeting.

 

Figure 2. U.S. Inflation Expectations Have Been Rising
Five-year, five-year inflation swap rate, October 10, 2017–September 10, 2020

Source: U.S. Federal Reserve Bank of St. Louis. Data as of September 10, 2020. The forward 5-Year, 5-Year Inflation Swap Rate is a measure of expected inflation (on average) over the five-year period that begins five years from today.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Returns during other times may vary. Due to market volatility, the market may not perform in a similar manner in the future. Like all investments, inflation derivatives involve specific risks that should be carefully evaluated. Although these securities are more complex than typical stock and bond investments, they entail similar liquidity and potential default considerations.
Past performance is no guarantee of future results. 

 

Moreover, the yield curve has steepened at maturities longer than those at which the Fed is expected to keep short-term rates at zero (see Figure 3). And forward yield spreads also have steepened, showing that investors are anticipating a renormalization of the term premium.

 

Figure 3. Yield Curve for Longer-Maturity U.S. Treasuries Has Steepened

30-year/5-year U.S. Treasury swap curve, September 30, 2015–September 10, 2020

Source: Bloomberg. Data as of September 10, 2020. A swap curve identifies the relationship between swap rates at varying maturities. A swap curve is effectively the name given to the swap's equivalent of a yield curve. U.S. Treasury swaps are pegged to U.S. Treasury securities and involve an agreement between two separate parties to exchange one stream of payments for another over a set period of time.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Returns during other times may vary. Due to market volatility, the market may not perform in a similar manner in the future. Like all investments, interest-rate derivatives involve specific risks that should be carefully evaluated.
Past performance is no guarantee of future results. 

 

But the Fed must now keep the faith by showing that it can transition from supporting liquidity to providing forward guidance that is forceful enough to assure investors that it will do as it has promised and maintain aggressive stimulus as the economy recovers, and for longer than it would have in the past.

Implications for the September FOMC Meeting—and Beyond

It appeared that changes to forward guidance about both interest rates and quantitative easing would be rolled out following the meeting of the Fed’s policy-setting Federal Open Market Committee (FOMC) on September 15-16. However, that timing now appears in doubt as several key decision-makers have indicated recently that it may not be appropriate to implement stimulus as long as the economy is still constrained by the presence of the virus.  

At some point, however, the FOMC will have to reassure investors that it has not forgotten the fierce urgency of now. Otherwise, it risks a reversal of the credibility it has gained from investors from its carefully constructed statement of its long-range goals. Asset markets will continue to watch developments after the September meeting to see if the Fed can strike the appropriate policy balance.

 

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. U.S. Treasuries are debt obligations issued and backed by the full faith and credit of the U.S. government. Income from Treasury securities is exempt from state and local taxes. Although Treasuries are considered to have low credit risk, they are affected by other types of risk—mainly interest rate risk (when interest rates rise, the market value of debt obligations tends to drop) and inflation risk. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Fed refers to the U.S. Federal Reserve.

Term premium is a gauge of the level of risk inherent in holding a longer-term bond versus a series of shorter-term securities. It represents the estimated risk embedded in a longer-maturity bond that is determined by the difference between the actual yield and the “risk neutral” yield (represented by rolling a series of shorter-term securities extending to the same maturity at current rate expectations).

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.   If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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