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Institutional Perspectives

Stabilizing markets and ensuring liquidity was only the beginning. Now, the U.S. Federal Reserve needs to chart a challenging course on inflation.

Read time: 2 minutes

Though the U.S. Federal Reserve (Fed) made its first move to support the coronavirus-stricken economy and financial markets in early March, the two-plus months that have elapsed may seem like a policy lifetime. During that time, the Fed has supported market functioning through aggressive balance sheet expansion, allowing the financial system to deleverage amid an unexpected volatility shock and a sharp increase in demand for U.S. dollar-denominated funding. Excess reserves are, once again, ample.

 

The Fed’s Balance Sheet: “Expansion” Is an Understatement
U.S. Federal Reserve Bank assets, July 2, 2008-April 29, 2020

Source: U.S. Federal Reserve Bank of St. Louis.

 

But the Fed has also been relatively successful in giving the market forward guidance that has convinced investors short-term interest rates will stay low for the next few years; the spread between a one-month U.S. Treasury bill and a three-year Treasury note was only 17 basis points (bps) on May 8, according to Bloomberg data. At the same time, the market appears to be getting increasingly comfortable with the idea that the economy will recover enough over the medium-term for short-term rates to rise eventually; the spread from the three-year/10-year Treasury spread has steepened to 48 bps.

 

Investors May Be Expecting Short-Term Rates to Trend Upward
U.S. Treasury yield spreads (as indicated), January 31, 2018-May 11, 2020

Source: Bloomberg. Data as of May 11, 2020.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Increasing confidence in short-run economic stabilization and medium-term recovery, along with new lending facilities from the Fed that provide financial support for corporate debt markets, have encouraged substantial spread tightening, even before the Fed has made any purchases. The tightening even extends into the lower quality rungs of the U.S. high-yield market, where the Fed is unlikely to buy anything other than what is embedded inside an exchange-traded fund (ETF).

 

Spreads Recently Tightened on Lower-Quality U.S. Debt
Option-adjusted spread on indicated rating categories within the Bloomberg Barclays U.S. High Yield Index, May 23, 2014-May 7, 2020

 

Source: Bloomberg Barclays Indices. Data as of May 7, 2020.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Even as balance sheet expansion continues and new lending facilities come on line, the Fed’s task is evolving. The central bank needs to transition from assuring market functioning during a substantial economic shock to implementing monetary policy that can prevent inflation expectations from falling and re-anchor them at its stated 2% medium-term objective. (The May 12 report from the U.S. Bureau of Labor Statistics showing a 0.4% decline in the core consumer price index for April lends added urgency to that job.)

With short-term rates at the effective lower bound (not far from 0%), this will prove a more difficult undertaking than what U.S. policymakers have accomplished over the past couple of months. It seems the Fed, which has already rewritten the policy playbook in the past few months, will have to get very creative to repeat its recent successes.

 

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